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LI B R.ARY OF THE UN IVERS ITY Of ILLI NOIS 332..Co<\ F°>8 p * 1953

FUTURES TRADING SEMINAR HISTORY AND DEVELOPMENT

Principal papers by: Henry H. Bakken Roger W. Gray Thomas A. Hieronymus Allen B. Paul

First Edition Vol. I

Mimir Publishers, Inc. Madison, Wisconsin 1960

Published by Mimir Publishers, Inc. Madison, Wisconsin

Printed in the U. S. A. by Worzalla Publishing Company Stevens Point, Wisconsin

SEMINAR PARTICIPANTS

GEORGE ABSHIER Agricultural Extension Service, Oklahoma State University Stillwater, Oklahoma VICTOR D. BENDEL, Victor D. Bendel Co., Chicago, Illinois BRUCE L. BROOKS Agricultural Extension Service, Washington State College, Pullman, Washington ARDIN P. BUELL John G. McCarthy Co., Chicago, Illinois DALE BUTZ Illinois Farm Supply Company, 100 East Ohio Street, Chicago, Illinois BERNARD P. CAREY Second Vice Chairman, Chicago Board of Trade W. S. FARRIS Department of Agricultural Economics, Purdue University, Lafayette, Indiana GERALD GOLD Commodity Research Bureau, Inc., 82 Beaver Street, New York 5, New York STANLEY JONES President, Winnipeg Grain Exchange, Winnipeg, Canada FRANK A. JOST, JR., Dean Witter & Co., Chicago, Illinois LEON T. KENDALL U. S. Savings & Loan League, 221 North La Salle Street, Chicago, Illinois WARREN W. LEBECK Secretary, Chicago Board of Trade ROBERT C. LIEBENOW, President, Chicago Board of Trade [v] ©1960 Mimir Publishers, Inc. WENDELL McKINSEY Department of Agricultural Economics, University of Mis souri, Columbia, Missouri FRED MAYWALD Manager, Grain Department, Farmers Grain Dealers As sociation, Des Moines, Iowa ROBERT MITCHELL College of Commerce, University of Illinois, Urbana, Il linois HOWARD RIES Oscar Mayer & Co., Madison, Wisconsin CLARENCE ROWLAND, JR. Chairman of the Board, Chicago Board of Trade ROBERT SCHMELZLEE Portland State College, Portland, Oregon C. P. SCHUMAIER Department of Agricultural Economics, University of Il linois, Urbana, Illinois ORLO SORENSON Department of Agricultural Economics, Kansas State Uni versity, Manhattan, Kansas FRED TAYLOR Department of Agricultural Economics, North Dakota Ag ricultural College, Fargo, North Dakota SAMUEL G. WENNBERG Department of Economics 2c Business Administration, Uni versity of Missouri, Columbia, Missouri WILLIAM T. WESSON Agricultural Marketing Service, U. S. Department of Ag riculture, Washington 25, D. C. WALLACE O. YODER Department of Marketing, School of Business, Indiana University, Bloomington, Indiana [vi] ©1960 Mimir Publishers, Inc. FOREWORD

Futures markets play a key role in marketing and pricing some of our more important agricultural commodities. This role is a changing one. Increasingly numerous and complex developments are affecting the services demanded of futures markets. Some changes are within agriculture, some with out. To some extent commodity exchanges such as the Chi cago Board of Trade may modify and help shape changes in our marketing facilities and techniques. Such institutions are also influenced by forces outside their control and, as a consequence, must seek new ways of providing more useful marketing services.

The program at which the papers and discussions in this volume were presented was an attempt to assess the role and function of futures markets in our changing and developing agricultural economy.

Specifically, the 1959 Futures Trading Seminar attempted to identify the important forces influencing futures markets and to help determine what might be done to enable futures markets to increase their contribution toward a more efficient and effective agricultural marketing system. The first pre sentation reviewed and analyzed the role and function of fu tures trading as these have developed historically. The next two sessions focused attention on two important functions of futures trading, risk shifting and pricing. The final ses sion was designed to' evaluate the future of futures markets in our changing agricultural economy. In planning the program, the Educational Advisory Com mittee secured qualified and capable speakers, discussants, and seminar participants who had a particular interest in grain marketing. As a result, the committee feels the quality of the analyses was very high. Differences of opinion were [vii] ©1960 Mimir Publishers, Inc. inevitable. The subjects were discussed by competent and interested students of futures markets at levels where existing knowledge had not previously provided conclusive answers. The committee is confident that this book presents an im portant contribution to the literature on futures trading. It should appreciably extend the boundaries of knowledge; and perhaps, one of its main values will be that of defining some frontiers for future work. This volume should be par ticularly useful to educators, researchers, and trade people in terested in an analytical discussion of futures markets.

The Educational Advisory Committee carried major re sponsibility in planning and conducting the Seminar, and was particularly appreciative of the freedom it experienced in planning the program. The committee was aided by Chicago Board of Trade personnel in selecting the industry discus sants, and wishes to thank Mr. Irwin B. Johnson, Director of Public Relations, and Miss Anne Holden, Editor of the Chi cago Board of Trade News, for the excellent assistance and cooperation they gave with regard to arrangements and publicity for the Seminar. Finally, the Educational Advisory Committee especially wishes to express its gratitude to the Exchange, its Public Relations Committee, and to Mr. Robert C. Liebenow, President of the Chicago Board of Trade, for support and cooperation which made the event possible.

Lafayette, Indiana Paul L. Farris, Chairman April 15, 1960 Educational Advisory Committee

EDUCATIONAL ADVISORY COMMITTEE OF THE CHICAGO BOARD OF TRADE 1959

Paul L. Farris, Chairman Professor of Agricultural Economics, Purdue University James R. Enix Extension Wheat Marketing Specialist, Oklahoma State University T. A. Hieronymus Professor of Agricultural Marketing, University of Illinois Taylor W. Meloan Chairman, Department of Marketing, Transportation and Foreign Trade, University of Southern California Charles W. Miller Director, Department of Marketing, Marquette University Ross Milner Extension Economist, Grain Marketing, Ohio State Uni versity

CONTENTS

Foreword VII

Part I.

Historical Evaluation, Theory and Legal Status of Futures Trading in American Agricultural Commodities Speaker: Henry H. Bakken, 3 University of Wisconsin Discussants: James S. Schonberg, 29 Uhlmann Grain Company John W. Sharp. Ohio State University .. 39 John D. Black, Harvard University 43 Discussion 49

Part II.

The Importance of Hedging in Futures Trading; and the Effectiveness of Futures Trading for Hedging Speaker: Roger W. Gray 61 Stanford University Discussants: James P. Reichmann, 83 Chicago Board of Trade C. Peairs Wilson, 87 Kansas State University Richard Phillips, 93 Iowa State University Discussion 99

Part III.

Effects of Futures Trading on Prices Speaker: Thomas A. Hieronymus 121 University of Illinois Discussants: Richard M. Withrow, 163 Lamson Bros. & Company Reynold P. Dahl, 173 University of Minnesota Geoffrey S. Shepherd, 181 Iowa State University Discussion 192

Part IV.

The Future of Futures Trading in Our Changing Agriculture Speaker: Allen B. Paul, 203 U. S. Department of Agriculture Discussants: Walter M. Goldschmidt, 245 Continental Grain Company Leonard W. Schruben, 253 Kansas State University Adlowe L. Larson, 257 Oklahoma State University Discussion 262 Bibliographical References Cited 273 Index 277

Part 1

Historical Evaluation, Theory and Legal Status of Futures Trading in American Agricultural Commodities

HISTORICAL EVALUATION, THEORY AND LEGAL STATUS OF FUTURES TRADING IN AMERICAN AGRICULTURAL COMMODITIES

Henry H. Bakken

Ac.CCORDIN G to one adage "history is something that never happened, written by a man who wasn't there." Another apothegm asserts that "the only history worth reading is that which was written by those who created the events they described." The original idea of contracting to buy or sell goods for future delivery was not conceived in the new world as some sources would have us believe. No one can be absolutely cer tain when forward transactions were first consummated, but recent findings by economic historians would indicate that the practice was in vogue in the 12 th century, among the traders of Asti and the Caravan Merchants at the medieval fairs of Champagne. We are not completely dependent upon historical accounts in understanding the evolution of market institutions. Market organizations can be found in all stages of develop ment even today owing to the uneven degrees of social and economic advancement extant in the nations of the world. This general cross-section view of markets showing progres sive gradations of development as they have come down to us from the past, range from a system of ceremonial gift-giv- [3] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR ing which now prevails among certain primitive tribes to the highly formalized modern produce exchanges dealing exclusively in futures contracts. Stages of Market Organization In my judgment there are at least five distinct stages in the evolution of market organizations. These are: 1. systems of gift-giving 2. barter 3. spot markets 4. contract markets (for specific delivery) 5. futures markets Not only are these stages of market development in full flower in some areas of the world today but all of them pres ently exist in attenuated form even in the most advanced so cieties. The participants in the first three stages are generally completely subjective in their determination of prices. In the transitional (stage 4) above in which specific con tracts to arrive," "contracts of sale" and others are en tered into, the principals may be partially objective in their valuation techniques. We prefer to think that those who trade in futures contracts (stage 5) are or should be com pletely objective in their judgments of value. Most of the current college texts on the subject of marketing emphasize (stage 3) utilizing a combination of commodity, agency, and functional approaches in their descriptive accounts of market operations. Much of their discourse actually concerns prob lems of production economics rather than the principles gov erning exchange. A number of them note the existence of futures markets (stage 5) but they gloss over its signifi cance lightly. The area of great interest to me currently is stage 4. A Gap in Market Literature The dearth of prose concerning the behavior of buyers [4] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS and sellers in this stage of market evolution constitutes a hia tus in marketing literature. The rising tide of interest in problems of integration, however, may inspire some scholars to give increasing attention to this neglected area. There is much we need to know about the nature of these transfers and how they effect the type, degree, content, and duration of rights to property under myriad forms of contracts and agree ments superseding spot market transfers but not attaining the status and perfection of futures contracts. It is my pur pose now to point out the salient ideas that have emerged from each stage of development and to indicate their significance to contemporary market organizations. All humanity has been persistent in its efforts to systemize exchange because the advantages derived therefrom are ob vious and indispensable as a means of providing some of the necessities of life. Our innovators of social and economic institutions, how ever, never seem to exceed the "bounds of immediate needs." This is so, perhaps, because our kind of society offers so little incentive to those who perform above and beyond the call of duty. Those who venture beyond these limits run the chance of acquiring a sobriquet such as "crackpot" or Don Quixote. Another cultural block to progress may be the difficulty of inducing their pragmatic contemporaries to adopt new procedures before they are forced upon them by internal or external circumstances. That part of my topic labelled, "Historical Evaluation," I presume is not circumscribed in the strict sense to American experience solely. On this assumption, I would like to open the door on events of the past wide enough so you may see and appreciate their connections and probable contributions to our existing market organizations. The musty records of medievalism reveal a few facts of [5] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR considerable value to us for a more comprehensive under standing of the evolution of market institutions. The transi tion from feudal isolation and provincialism to a commercial era was not sudden and dramatic. The tempo of trade was geared to the cadence of the camel and the speed of the sail. Ostensibly, it took about 800 years from the 5th to the 12th centuries to evolve a few elemental ideas about market or ganization. After the fall of the Roman Empire, a process of disinte gration set in because the remnants of government left as a bequest from the Romans were too weak internally to sus tain a united centralized system. At most of the outposts the petty officials seized control and claimed it as their prerogative to rule. The territory which is now France, England, the low countries, and Ger many was shattered into hundreds of fragmentary units and each unit became an armed camp which sooner or later waged war on neighboring localities. Warfare induced van dalism, incited robbery, rendered private property precarious, and endangered personal freedom. It was an age of violence. Community after community reverted to a state of self- sufficiency as was their status in more primitive times. Com mercial intercourse sank to the lowest ebb on record, but it never completely disappeared. There were some transac tions, at first, limited to a few refined articles of jewelry, precious stones, fine cloths, spices, slaves and swords. The commonplace items of trade between the feudal estates were salt for curing meats, tar as a preventive for diseases in sheep and some crude metals to shape tools and implements. Throughout these raw centuries most exchange was ne gotiated on a barter basis. Gift giving on an equivalent basis was not uncommon and a limited amount of trade was settled in coins and nuggets of gold or silver. [6] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

Trade at Low Ebb The price these forebears of ours paid for such retrogres sion was hunger and famine. Even after they introduced a number of innovations to facilitate trade they experienced as many as 22 famines in a single century — the 13th. In six centuries from 1000 to 1600 there was on the average one lean year in every 12. When we read about the "History of the Grain Trade of France" by Usher and "The Evolution of the English Corn Market" by Gras we can appreciate some of the limitations of their market systems. It gradually dawned on these people that their plight was attributable more to their ignorance than to the forces of nature. They learned through experience the value of organization and efficient administration of human affairs. The impelling motivation was a desire for peace and a mutual exchange of ideas and wares as a means to creature comforts, security and happiness. Out of these urges and desires came the re birth of commerce predicated on specialization in trade and production stimulated by the guilds. The Period of Nomadic Traders For the first 16 centuries of the Christian era, however, the flow of goods in many places throughout Europe was still so tenuous it would neither support resident merchants nor continuous local markets. The kind of market organization that emerged from this milieu had its origin in the migra tory movement of people who cut across national boundaries in their pilgrimage to distant meccas. Their encampments at favored watering places and crossroads brought them into contact with the natives and other wandering bands. The lure of gifts and the opportunity to barter domestic products for exotic things from other lands provided the essential social solvent for mutual intercourse. Gradually a system of seasonal fairs held on staggered dates at strategic locations

[7] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR grew out of these chance meetings of migrants. Owing to a great increase in the supply of precious metals and systems of coinage, much of the trade in this period shifted to stage 3 and accounts were settled in cash as the traders carried away their purchases. The Feudal Peddlers In the worst periods of feudal isolation every stranger was looked upon with suspicion, especially the stranger bear ing articles of wealth. He was often assailed, robbed, and sometimes made a slave of his captives because he had the termerity to intrude in a place where he had not been born, where he was unknown, and without friends or relatives. Even in the face of these dangers, the lure of profits from trade persisted and a class of itinerant peddlers gradually formed to extend the business of trading into the hinter land. These were the feeders of the fairs, otherwise the medieval fairs may never have attained the eminence claimed for them in the period 1100 to 1400 even though they served primarily as centers for international trade. While transactions were being consummated on a cash basis or credit basis at the fairs, trade by the feudal peddlers off the beaten paths of com merce was still arranged largely on a barter basis, especially throughout the 12th to the 14th centuries. Trade Barriers There were many obstacles to trade in those times in ad dition to the hostility of mankind. These were: the neces sity to conduct most trades in terms of barter. Varietal scarcities of goods, inadequate mediums of exchange, lack of precious metals, the prohibition of usury, no credit system, poor roads, and virtually no transportation facilities. The petty rulers remote from the high roads of commerce were either unwilling or unable to provide protection against violence to life and property for those who desired to traverse [8] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS the manorial estates to reach some hamlets where they might trade. Some of these benighted leaders seized the oppor tunity to exact a tribute for rights of passage winning for themselves the dubious appellation "Robber Barons." The Fairs of Champagne Eventually, some enlightened sovereigns decreed laws to protect the rights of these traders in their travels, legalized their transactions before witnesses, and granted them val uable franchise for a consideration. One of the foremost areas granting such privileges to migrant traders was Central France. The most famous fairs of medieval Europe were founded in the rich county of Champagne. These fairs were ultimately integrated into a grid of fairs under central au thority controlling a geographical area extending from the low countries to the major Italian ports of the Mediterranean Sea. Medieval Market Fairs* Date of Major commodity Commercial centers franchise specialties Troyes, - warm fair 1114 Linen, wool St. Remi cold fair — Leather, skins Provis, • autumn fair 1137 Silk, furs St. Ayoul May fair 1138 Wine, livestock, salt, tar Bur-sur-aube, Easter fair 1114 Grain, honey, cheese Lagny, su-marne January fair 1154 Wax, dyes, rope *Bakken, Henry H. Theory of Markets and Marketing, p. 317, Mimir Publishers, Inc., Madison, Wisconsin, 1953. According to one historian, even the oldest records, 1191- 1197, describing this trade between merchants from North and South Europe were not, by many generations, the earliest instances of such trade. The channels of trade in which these merchants carried on their business operations was too wide and too deep to have been constructed overnight.1 The strongly founded credits of the merchants individually and collectively could not have been built up in a short time. 1 Reynolds, Robert L., "Genoese Trade in the Late Twelfth Century," Journal of Economic and Business History, Vol. Ill, No. 1, p. 381, Harvard University Press, 1930. [9] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

The fortunes of these traders were impressive and the total capital turnover each year might have inspired respect in any generation until comparatively recent times. Trade in these fairs and travel to and from these centers of trade occurred with such clock-like regularity that it is evident that many of the obstacles to overland commerce prevalent in much of feudal Europe had been either elim inated or minimized in the main trade routes extending North over the Alps and South from the low countries terminating at Champagne/ The Origin of the Merchants Code The medieval fairs were complex institutions. They were not only great centers of barter, later becoming the major spot markets of Europe, but their occurrence was a great social event. First and foremost, the market places situated in the main channels of trade were generally recognized as a sanctuary where individuals might seek refuge and remain for a time inviolate against the vindictive retaliations of their enemies. The fair merchants won the right to hold their own courts of justice. These were summary courts in which all the merchants present excepting the plaintiffs and defendants acted as jurors. The on-the-spot decisions made in these pie poudre courts in time became known as the mer chant's code applicable on an international basis wherever the medieval merchants convened for purposes of trade. The merchant's code eventually was incorporated into the common law and even today exerts its influence upon the manner in which we settle our transactional disputes in courts of law. A close parallel of this right to settle internal disputes relating to trade may be found in the business con duct or other interorganizational committees on the com modity exchanges in this country.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

The itinerant merchants came into their own as a dis tinguished class in this era of trade and adventure. Their activities as money lenders to the nobility and the clergy served them well in rising from a position of low status to one of affluence and respectability. To these remarkable men goes the credit of perfecting parol contracts for future deliveries of merchandise at suc ceeding fairs. These contracts, however, were strictly non-negotiable agreements limited to transactions between individuals on a personal basis. "Fair Letters" Predecessors of Bills of Exchange Mutual trust among the merchants was cultivated to the point where their word "was as good as gold." They fa cilitated their business dealings with another innovation called the "fair letter." This was a means of transferring credit balances or granting new credit from one merchant to another. The "fair letter" was actually an early version of what is now known as a bill of exchange. The accumulated credits of the "fair letters" were honored by the Goldsmiths at their depositories often removed hundreds of miles from the fairs. From Goldsmiths to Bankers The "fair letters" of the caravan traders were in the be ginning limited to bilateral transfers. Later they were made negotiable for an esoteric class of merchants, and eventually they became negotiable instruments of credit when proper ly endorsed for all traders. At this point in the evolution of commercial transactions, the goldsmiths expanded their op erations from simple bailees to become bankers specialized in the business of dealing in negotiable instruments of credit and making loans based on the gold and silver deposits they held in trust for their patrons. [11] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR

Time Contracts Some writers claim that dealing in iron warrants was a form of futures trading which originated in England early in the 19th century.3 I have not been able to authenticate this claim on two counts. The authorities are not even close to agreement on the date of origin. Moreover, iron warrants appear to be a form of warehouse receipt representing title to a specific lot or quantity of goods. Trading on the basis of these warrants, then, would more closely resemble con tracts "to arrive" rather than bona fide futures contracts. The English grain traders were experimenting with a type of agreement for the future delivery of specified lots of wheat as early as 1821 according to court records, but I believe these agreements were "contracts to arrive" rather than futures contracts as we distinguish them.4 Moreover, the court questioned their validity. One ingenious seller apparently hit upon a plan to make money by selling nutmegs which he did not own, and which he did not specify by lot, sample, or grade. This case of Bryan V. Lewis in England — 1826, is, of course, an isolated instance where the buyer and the seller, one of them being a minor, stumbled unwittingly into an agreement quite like a futures contract.6 There were undoubtedly many other instances both here and abroad of a similar nature among the thousands of agreements detailing future delivery of various commodities. No great significance can be attached to these random transactions since they were not purposely designed to transcend time contracts (stage 4) in an organized manner to assure continuity of action.

3 Hoffman, G. Wright — Hedging by Dealing in Grain Futures, p. 13, Democrat Printing Company, Madison, Wisconsin, 1925. 4 Lorymer and Smith, IB and CI, 3 (1822), Hibble, White, V. M. Morine, Meeson & Welsby reports of cases argued before courts of exchequer, Vol. 5, pp. 462-466 (1838). 5 Bryan V. Lewis, Ryan and Moody 386 (1826). [12] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

Turning to the American scene, we also find early court cases relating to agreements to make future delivery even though the seller does not own the thing he sells.8 The question arises, when were the traders formally organized to buy and sell contracts? Baer and Saxon claim that a Pro duce Exchange was first established at the foot of Wall Street, New York, in 1752; that the New York Stock Exchange was founded 1792 but its first constitution did not become ef fective until 1817.' An earlier attempt on my part was made to nail down the dates and places where grain exchanges were first formed in this country. The merchants of St. Louis claimed the honor of forming the first grain exchange in the summer of 1836. The partisans of Buffalo say they organized the corn exchange in that city in 1844. The New Yorkers say their Produce Exchange was or ganized in 1862. The Board of Trade of the City of Chicago was formed in 1848. Some of the early organizations were short lived owing to schismatic influences, lack of interest, or civil strife. Judging them on the basis of continuity of existence and manner of operation the Chicago Board of Trade is generally conceded to be the oldest and most im portant market for agricultural commodities in this country. We can be quite certain, nonetheless, that the Chicago grain dealers were among the first to adopt a technique which had been first evolved by the caravan merchants in the Champagne fairs six centuries earlier. One contractual transaction of record in the sale of wheat was reported by a Chicago paper as early as 1845.8 Was the art of dealing in "time contracts" lost and rediscovered several centuries later, or was knowledge of this method of trading handed down in

'Dodge vs. Van Lear, Federal Case No. 3956, D. C 1837. 'Baer, Julius B. and Olin G. Saxon, Commodity Exchanges and Futures Trading, Harper and Brothers, 1949, p. 10. 'The Chicago Democrat, December 31, 1845. [13] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR some mysterious way and adopted by the founders of the American commodity exchanges? To my way of thinking, a great idea may be abandoned for a while but it is never lost to posterity. It is not so important, perhaps, to know the precise date when and where a new principle was con ceived — except for celebrating anniversaries. What is really significant is to recognize its inherent value and how and why it was adopted. One of the best studies to enlighten us on this question is by Irwin. Incidentally, he obtained first hand accounts directly from the men who made history in organizing the Chicago Mercantile Exchange. He states that "In each instance, analysis shows that futures trading, un organized or organized, developed gradually evidently to meet specific marketing needs. In eggs and butter such needs clearly arose from the added problems which resulted from the accumulation of seasonal surpluses by dealers. In cotton and grain the same conclusion seems to be warranted al though the evidence is less complete. In each instance the time contracts which preceded organized trading arose in response to marketing needs, developed over a period of years as the commodity market grew in size and complexity, and ripened into organized trading in futures."9 At first, many time contracts were either verbal agreements or a simple memorandum kept by each party which only specified the price, quantity, and range in time of delivery. They were bilateral in structure and quite personal. Over the years the time contracts were appreciably refined to the point where they were printed, standardized forms, negotiable, impersonal, and more specific as to quantity, grade, and time of delivery. Organized trading in time contracts under went many changes during the last half of the 19th century

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS before attaining full stature, and maturing into futures con tracts.10 The Origin of Futures Contracts The amazing thing about the evolution of futures trading is the length of time required to proceed from ordinary spot transactions (stage 3) to dealing in time contracts (stage 4) by organized traders in each commodity. Once a pattern is established it is rather quickly diffused within particular commodity trading groups. The butter and egg merchants made this transition in ap proximately 25 years. Then it required another 20 years to get into the business of dealing in futures contracts (stage 5) or a total span of 45 years — 1874 to 1919. Irwin estimates that it took the grain and cotton merchants a total of only 20 to 25 years to make the transition and this feat was accomplished a quarter century earlier. A recent report suggests that the transition was made in 16 years in wheat trading — 1851-1867." We may conclude from these arresting facts; firstly, that progress toward futures trading in some commodities is appreciably slower than in others, and secondly, futures trading is contagious but it's a slow form of contagion. "The Mills of the God's grind slowly, but ah, they grind exceedingly fine." Of one thing we can be quite certain, based on the evidence at hand, the Chicago grain merchants were the first men in the world to formulate a new highly negotiable impersonal type contract designed to facilitate the transfer of titles to unspecific lots of commodities in a continuous manner on an organized exchange adapted to that purpose. When this form of futures trading came into existence, it opened the way for hedging transactions. Hoffman suggests

FUTURES TRADING SEMINAR that the hedging of corn on the part of country grain dealers became common sometime in the 1870's and hedging of wheat in the 1880's.12 Close on their heels followed the cot ton merchants of New York in perfecting a similar kind of futures contract.

Legal Status of Futures Trading Mark Twain once observed — "October, this is one of the peculiarly dangerous months to speculate in stocks. The others are: July, January, September, April, November, May, March, June, December, August, and February." Ever since traders began speculating, the legislators have been "kibitzing." One of the first acts of record occurred in Hol land, year 1610, when an ordinance was promulgated prohib iting short selling. For more than 300 years following this act, the executive, legislative, and judicial branches of gov ernment have continued to be a vital force of influence on futures trading. In former years they attempted in many different ways to curb or prohibit the act of short selling commodities and stocks. Some of the methods used were so arbitrary they deprived individuals of their constitutional rights. Others were so capricious they seriously jeopardized the total commerce of the Nation. Almost without exception, such restrictive decrees, laws, rules, and ordinances were eventually repealed or winked into oblivion.

Other laws designed to administer and regulate business activities in a manner to avert fraud, eliminate abuses, curb unethical practices, prevent discrimination, and as sure justice to all alike are indispensable, and in the public interest. It is a patent fact, historically, that many members

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS of the Commodity Exchanges were slow to recognize that they owed any obligations to the public. This kind of atti tude was not uncommon in the formative years of the Ex changes — the years of rugged individualism and laissez faire philosophy in commerce. The associations these men had formed were, in their opinion, private clubs. Many of them were guilty of loqua cious and misleading statements which only served to in tensify suspicions. They condoned abuses and defended such ill-considered practices as periodic raids on the market for the purpose of cornering and squeezing the shorts. Manipu lative practices created considerable mischief among the traders, but the sagacious ones were not always able to thwart such infamous tactics summarily. These spectacular forays on the Exchanges attracted wide public notice and created unfavorable public impressions of their functions and purpos es. In such doings the public's memory is interminable. The excesses in the last quarter of the 19th century long plagued all terminal market organizations.

Contemporaneously, an ever-increasing number of agri cultural producers migrated westward to exploit the fertile prairies and seed them to endless fields of corn, wheat and other crops. The new railroads accentuated this movement and soon the markets were flooded at the railheads, overtax ing storage capacity, handling equipment, and marketing fa cilities to the breaking point. Out of this agrarian cauldron came scalding criticisms against the liberal subsidies in the form of land grants to railroads equal in total area almost to four states — Iowa, Minnesota, North Dakota, and Wis consin. They decryed uncertain markets, erratic prices, high service costs, abuses in the issuance of warehouse receipts, and speculative practices in the Commodity Exchange. [17] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR

The Granger Uprising A new farm organization came into existence in this pe riod to solidify the demands of the farmers. They insisted on broad programs of reform through whatever means neces sary to achieve their end. The brunt of this agrarian attack centered on service agencies and market institutions in the state of Illinois. The legislators responded by amending the constitution — adding Article XIII. They passed the warehouse acts, the carrier acts, and imposed restrictions on dealing in futures contracts. It is to the credit of the Commodity Exchanges that they tightened up their operations, and put their house in order administratively. The astute men of the Exchanges, inter ested in continuous services essential to all factors in the trade, asserted their authority by establishing definitive rules and means for their enforcement. They realized that if they were not alert in correcting the defects within their own organization, the government might do so in a less benign manner. Growing out of this internal control came the perfection of futures contracts and other edifying changes. A second tidal wave of malediction critical of the mar keteers came in the agricultural recession following World War I and the economic cataclysm of the thirties. Owing to the activities of agrarian pressure groups, our elected repre sentatives were in a conciliatory frame of mind. They ini tiated a number of major reforms highlighted by such legis lation as the Capper-Volstead Law, the Grain Futures Act, the Agricultural Marketing Act, the formation of Farm Credit Administration, and the Commodity Exchange Act. A Plethora of Bills In retrospect most of us can agree that some if not all of these laws had a bracing effect upon the organized markets, although many of those who had to adapt themselves to the

[18] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS new order may have rued the day. From 1884 to 1953 at least 330 bills were introduced in Congress designed to regulate, investigate, delimit, prohibit, or otherwise obstruct trading in futures. In fairness to our representatives in Congress it must be said that they have, with one exception, held at bay the would-be vandals who sought to tear down a market structure that has taken a century to build. In some states the lawmakers have been less statesmen-like in their attitudes toward contract markets. In the fermentative years, 1890 to 1924, Congress author ized no less than 30 different investigations which in one way or another affected the grain trade appreciably. Despite the abundance of such inquiries in the past, there is no assurance against a repetition of this experience in the future. It is likely, though, that critical attention will be shifted from those commodities long traded in futures to commodities most recently added to the list. Late in the 18th and early in the 19th centuries the free traders emerged victorious over the privileged traders franchised by the crown. This struggle for an open market lasted more than 300 years. During this long corivalry the free enterprisers with some semblance of organization fell into the habit of simply making verbal agreements. These personal, bilateral agreements were presumably limited at first to petty business transactions, but eventually their use was extended to commitments on the stock and commodity exchanges. The parol contract, however, was not the most effective instrument for transferring titles to things which had not yet come into existence or which the sellers did not possess. Not until the 17 th century were these contracts made im personal and negotiable, even then, they were limited to certain types of business. By the 19th century, their use was

[19] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR diffused generally, but when they became freely assignable, new difficulties arose to restrict transfers of property rights. The judges who sat on the high benches and the public were still subjective minded in their concept of business transac tions. The judiciary could visualize the necessity of buying and selling commodities already in existence for future de livery because of seasonal production, anticipation of needs, or the possibility of a rise in prices. They failed, however, to understand the counterpart of such transactions — selling the market short for a fall in prices. This procedure was alien to their thinking, and the courts refused to give their consent to this form of trading for the greater part of two centuries. If they understood the principle involved, they still feared the consequences of this revolutionary method of transferring titles to goods. These lawmen of other years found it difficult to distinguish this form of exchange from gambling. Gambling Versus Speculation Gambling has been defined as an agreement between two parties whereby the transfer of something of value is made wholly dependent upon chance in such a way that the entire gain of one party is the entire loss of the other. Its practice has been generally considered inimical to the interests of society in most countries where high ethical standards are maintained. As an aside, one might say, "And yet, in many countries National lotteries are legalized." The hard headed businessmen of the 19th century insisted that inherent risks were a part and parcel of all legitimate business enterprises, and that it was quite logical for some persons to specialize in assuming such risks. When the serv ices of professional risk takers are recognized as being legal, then, hedges against price changes become a reality for those who would rather not assume such risks.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

The Intent Test It became apparent to the judges that this manner of trad ing was increasingly prevalent both here and abroad and on re-examination they found such agreements of purchase and sale above reproach. The traders, however, began cutting corners by waiving deliveries and settling differences in mar ket values between purchase and sale with simple cash pay ments. The courts held these deals to be wagers in disguise and consequently invalid. It became a procedural matter in each case to analyze the motives of the parties to an agree ment to determine the validity of such transactions. In a famous English case (1852) the court evolved the "intent test" to implement the business procedure in such agree ments.13 This test was made unmistakably explicit in the following quote by Justice Matthews 32 years later. "... a contract for the sale of goods to be delivered at a future day is valid . . . when the parties really intend and agree that the goods are to be delivered by the seller and the price to be paid by the buyer; and, if under guise of such a contract, the real intent be merely to speculate in the rise and fall of prices, and the goods are not to be delivered, but one party is to pay to the other the difference between the contract price and the mar ket price of the goods at the date fixed for executing the con tract, then the whole transaction constitutes nothing more than a wager, and is null and void."11 Thus, the intent test became the cynosure of all lawmen, but its usefulness was al ready seriously impaired when Matthews so eloquently stated its principle. After 1885 a strict subjective attitude was abandoned be cause rigid adherance to the test could result in an injustice

FUTURES TRADING SEMINAR to one of the parties who acted in good faith in making the agreement while the other party invalidated the contract by his acts. The courts were rather awkwardly forced into the position of declaring that in order to judge time contracts as a wagering proposition, then, it was necessary to show that both parties must have mutually agreed not to deliver or to receive the goods according to the terms of the agreement. This concession of the courts swept away half of the intent test and made the other half less effective. Right of Substitution From the very inception of futures contracts, the parties to the transaction reserved the right to close out the deal to a third party. The right of substitution was a feature of convenience and necessity to uninterrupted trade, and it is to be distinguished from mere assignment.1* Should either party find it expedient to change his mind and settle the dif ference by a cash settlement after a contract has been proper ly formed it will not invalidate the agreement. The courts had the onerous task of winnowing the spurious from the valid speculative contracts.18 As time went on it became more and more evident that dealings in futures contracts were pri marily settled not by delivery of the physical product, but by cash differences as in the case where two hedger's contracts either by design or accident offset each other. The pit trad ers and scalpers who end the day "even", have no intention obviously to receive or deliver the physical commodity. Complexity of Contracts and What Constitutes Delivery The mercurial nature of futures trading requires an ex peditious system operating at high velocity in transferring legal rights and titles. A majority of the contracts run the gamut from customer, to broker, to the clearinghouse. These

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS contracts are not only made readily negotiable, they are con solidated, assigned and reformed into substitute contracts by process of cancellation in the clearinghouse operations. This device tends to blur any distinctions between disclosed and undisclosed intentions of the parties to the contract and it makes effete the subtle agreements or understandings con cerning any particular deal. When the courts attempted to ascertain the intent of the parties to such tortuous series of contracts, their task became insurmountable, and the intent test had to be discarded as useless. All that remains of conse quence is that either party may materialize the original con tract by simply waiting until the time arrives for performance. But even this is not essential for brokers. Contravening the common law rule, the Supreme Court has ruled that mere substitution by "ringing out" or "setting off" in the clear ance of contracts constitutes delivery.17 Some attempts have been made to revitalize the intent test by enlarging its scope to include "particular circumstances." This simply means that the judiciary will "play by ear" rather than from sheet music. The brutal truth is, as mat ters now stand, the courts have no open sesame or doctrine of consequence to test the validity of futures contracts other than precedent and herein lie the dangers of a cultural lag. Settlements by Arbitration Limits Litigation The number of transactions completed on organized ex changes runs into the millions each year and nearly all of them are concluded with the minimum of discord. Members of the exchanges agree as a condition of membership to ar bitrate all disputes relating to their trading on the Exchange. The decisions of the arbitration committees are final. Ap peals, however, are sometimes granted as a regular procedure or by special concession. The Exchange may refer a case to

FUTURES TRADING SEMINAR a court of law or equity on suggestion of the disputants. This quiet means of resolving differences is inexpensive, expedi tious and effective. In the first hundred years, 1850 to 1950, there were 616 law suits on record involving transactions classified as specu lative dealings, sales for future delivery, options, payment agreements, and wagers. Only 48 of these were brought into the Federal courts. In the decade 1926-1935 a total of 61 suits were instituted in State and Federal courts, a majority of which involved dealings in grain, cotton, or securities. Dur ing the next ten years, 1936-1945, only 38 citations are re corded. It is estimated on the basis of these data, not more than 650 cases of record will be found relating to futures transactions since their inception in this country. In concluding my comments on the legal status of futures trading in this country may I suggest that the economists have a responsibility in outlining for the courts the main points of consideration in determining the nature of com mercial contracts and a definitive statement of their purpose. On one occasion I suggested the following criteria as a starting point in determining the validity of contracts used in the futures market. These were: 1. Is there a natural or inherent risk which must be borne by someone in the market process? 2. Does this type of market render necessary economic services? 3. Is it in the public interest? 4. Are third party interests jeopardized by its existence in a commercial society?

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS or a science is still in "knee pants" status. Most text books on the subject are descriptive and elementary in context, stressing spot market operations to the exclusion of futures trading. The widespread use of contracts of a transitional nature bridging the chasm between spot markets and fu tures trading deserves much more attention than has been given them. The evolution of our Commodity Exchanges and the role they have played in our economy merit serious study not only for their great contribution in expediting distribution but for their potential as a rich area for theoreti cal speculation. The few generalizations presented in this paper stem pri marily from the historical, legal approach and are institu tional in nature. It is my hope that they will at least stimulate lively discussion should they otherwise fail to either inspire or enlighten my conferees. Is Futures Trading Circumscribed? Most of our contemporary writers seem to be in agreement on one point. They contend that trading in futures contracts is circumscribed in its application to a limited number of commodities. The reasons given in support of this view are several which cannot be listed in the scope of this paper. Subsequent events in my opinion have proven this thesis en tirely fallacious. Futures contracts have been "tailored" for more than 40 different commodities representing all de grees of perishability, homogeneity, variability in demand and in price, etc., and the end is not yet. A close examination of this question leads me to the con clusion that most of the limitations are more imaginary than real and the fictional ones were based on too few observations of a technique not yet fully evolved. These writers gave too much attention to the physical attributes of the com modity when their attention should have been riveted on the [25] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR techniques of trading. Net Possession Utility It is the business of the marketeers to create net possession utility. This means an actual rather than a fictitious trans fer of titles to goods, services, and properties. A number of writers have categorically stated that the principal economic function of commodity exchanges is to provide a means for hedging transactions. The tendency to overstress this fea ture of futures trading is understandable since the principals engaged in dealing in futures have been reviled so often and so rudely in the past that they may have become sensitive to public censure. The inclination is not to "stick one's neck out, but to draw into one's shell." The consequence of this attitude is to put major emphasis on the insurance feature of forward trading since it is a respectable form of business uni versally acknowledged as legitimate and essential. The truth of the matter is that the act of hedging sets off one transaction in apposition to another with the net result of zero ownership. The hedgers take no position in the mar ket. They transfer this risk of ownership to others. They do serve a useful purpose, however, that of feeding business into the maws of the exchanges and they justify the existence of speculators. The real function of commodity exchanges is that of pricing, publicizing, and transferring legal rights and titles to the things bought and sold. The speculators are the ones who perform these essential tasks by assuming the risks with their own resources based on their own judgments what ever their sources of information may be. The Dual Market System Another heresy of mine concerns the coexistence of the two major market systems. The curious relationship which exists between spot and futures markets is one that might merit much more study for its theoretical implications. These

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS markets both complement and supplement one another but they are actually independent entities. The spot market is one where titles to specific lots of phys ical goods may be bought or sold to fulfill definite require ments. Failure to make delivery in these instances might result in a real economic loss and cause considerable incon venience to the principals who intended to deliver and re ceive the physical commodity. Buyers and sellers normally enter this market with the clear purpose of getting or dis posing titles to particular goods which may not be fungible or duplicated in kind, degree, or quality. A breach of these contracts settled in courts of law should entitle the aggrieved to specific preformance or adequate compensation to obviate an economic loss which may in some instances exceed the actual value of the original goods. Elucidating further, the function of a futures market can be sharply delineated from that of the spot market. Its pri mary role is one of determining current base prices and projecting them into the future thus creating wealth, pos session utility — generally in the form of purchasing power. The goods named, e.g., cotton, copper, or coffee, are actually chimerical. Those who enter this market do so usually with the clear intention of securing an equitable right. In case such contract is breached, the remedy is sought in a court of equity. It is thought by most people that these markets are inex tricably bound together by the right of delivery. This fig ment of delivery, however, is a vestigial remnant of an age old custom, a slender strand of gossamer that is easily severed, freeing the two to go where they will in fulfilling their des tiny. The gordian knot is severable once the secret is known. From the evolution of market systems and techniques sketchly outlined in this paper, I conclude that futures trad-

FUTURES TRADING SEMINAR ing represents the highest type market institution man has thus far formulated. It is a practical way to expedite and direct the flow of goods and commodities into channels of use in an efficacious manner. If we can manage to maintain a free economy, this type of market organization will even tually be used to clear the trade for all, or substantially all, agricultural products, and a great volume of manufactured goods. It may take another hundred years, but look to the past and note, sirs, how far we have come in the first 100 years. In light of the extensive manner in which governments have interceded in the business of pricing and directing dis tribution, and the stark reality of a decreasing volume of sales on the exchanges, this may seem to some of you a brash prognostication. Reminiscent of the fable about the King who offered the hand of his daughter and his kingdom to the one who could compose a perfect sentence, you will recall that the winner penned these immortal words, "These things too, shall pass away."

Historical Evaluation, Theory, and Legal Status James S. Schonberg Futures trading, like progress, comes from planning ahead and profiting by using the past and present as guides for what lies ahead. The world would not have advanced with out this conception. Those who have a trade or carry on a profession are look ing to the future — an artist paints a picture for the purpose of selling it when he finds a buyer or a patron orders a portrait to be painted for posterity. We contract to have a house built — for future delivery. The contractor estimates the cost of building it and his profit. The component parts of the building depend upon previous planning ahead — looking to the future. The value of the house is based on lumber which has followed the cutting and replanting of trees, mining of ore, making of bricks, transportation and the many reasons that establish the prices of materials and labor in a free society. Even if we disregard the "free" in society and look at it in a much broader sense, history tells us that natural laws prevail. Autocrats and dictators have had to follow the ways of free peoples outside their domain even though they domineered those under their authority. So cialistic economies have had to compete with free enterprise in other parts of the world. Whether it has been the mar keting of agricultural products or procedures connected with other lines of endeavor, the trend has been related to the times through which the world was passing. As times went on tradesmen made rules to follow which were based upon the current practices and those rules were written into laws. The laws themselves have run the gamut through trial and error. So has it been with futures trad ing in commodities. These ideas of trade were not precon ceived, but rather they followed the developments of time.

FUTURES TRADING SEMINAR

Certain historic events, advancements in methods of farm ing, and inventions were forerunners of the present grain marketing system. The settling of the middle western part of the United States, throwing its vast fertile plains open to farming and the cheap transportation on its rivers, was an enormous spur to agriculture. Later, the opening of the Illinois-Michigan Canal in 1848 connecting the Illinois River and Lake Michigan brought with it the necessity of finding larger markets for the corn grown adjacent to these water ways. Corn grown in abundance but not ready for shipment in the fall before the canal froze up was stored in these loca tions in numerous cribs. During the winter dealers found it expedient to inquire of Chicago merchants as to the price they would pay for corn to be shipped when the corn had dried sufficiently for safe shipment along the canal when it was again open in the spring. These "to arrive" contracts became the practice and relieved the dealers of the specu lative risk of owning the corn during the long winter period. Speculative risks for wheat, which came to Chicago via the newly built railroads, were also great in the early days of the Chicago Exchange, particularly in wheat purchased after the close of navigation on the Great Lakes in the fall. Such grain could not be shipped until the following spring, and substantial stocks were accumulated during the winter. These types of holdings led to the shifting of risks by transfer of contracts on title to the grain. In time the prac tice became the custom. To this day there still exist broad markets in commodities on this type of trading — non-regu lated "forward delivery" markets. When time of delivery becomes current, shipment is made to the ultimate buyer's destination and by means of "rings" the intermediate trad ers exchange price differences. Customarily no margins are

[30] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS put up on these contracts although they may be based upon the rules of a trade organization. The Chicago grain men followed a different course than the non-regulated markets. In recognition of the persons composing the Chicago Board of Trade, the Illinois Legis lature issued them a charter in 1859 and by which, except for superseding state and federal laws, the Exchange is a self governing body. The Exchange, even before receiving its corporate charter, instituted the system of measuring quan tity of grain by weight, replacing cubic measurement, and inaugurated a system of quality inspection for grade. The latter has since been replaced by United States official grades. Bulk handling of grain makes it more readily storable and grading has many advantages. Because of grading, the farmer has an incentive to farm well as his return will be determined by the quality of his crop. He is provided bank credit on the basis of his grading certificate. Grading provides the basis upon which marketing, future sales, and hedging be come possible. The Exchange did not foresee futures trad ing when weight and grade requirements were instituted in the trade dealings, but they were part of the evolution. Other conditions led the directors of the Exchange to take cognizance of developments and early in the 1860's rules were passed. Later came other, more comprehensive ones for enforcement of verbal or written contracts, and providing for a requirement of margins on trades as well as some stand ardization of delivery and payment. This was all before there was futures trading in grain. Gradually futures trad ing became a reality, probably in the middle 1870's, but it is believed that the idea of transferring market risk from deal ers to speculators without actual change of possession of grain was not conceived for some time. During the early decades of the Chicago Board of Trade [31] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR much difficulty ensued over warehousing and warehouse re ceipts, also enforcement of railroad requirements to deliver incoming grain to all elevators. These differences were ad justed by state laws and agreements with the railroads. How ever, other problems continually arose necessitating addi tional rules and some litigation. Much later Congress passed the United States Warehouse Act authorizing warehousemen to store grain under its provisions in lieu of state laws. An other federal law is the Commodity Exchange Act which makes it mandatory for futures commodity exchanges to qualify and be designated as contract markets, and for firms and brokers to obtain licenses. The act also exercises powers over non-members of exchanges using the futures markets. An important feature of the law is that all customers' monies must be segregated from futures commission merchants' funds; funds equal to customers' debit balances must be placed in the segregated account by the commission merchant; margin deposits and credit balances may be deposited in clearing houses, etc. to margin customer's trades. The law, however, has no control over margins that commission mer chants may call from their customers. In most cases minimum margins are prescribed by the exchanges. The C.E.A. by reg ulation limits the amount of speculative trade by individuals or the quantity of their open interest. The C.E.A. requires regular reports by customers and clearing firms. By law the C.E.A. Sec. 5 (a) (7) states that each contract market shall require that receipts issued under the United States Warehouse Act shall be accepted in satisfaction of any futures contract, etc. In Chicago it so happens that all the elevators are so licensed. This removes the authority of the Exchange over the elevator operations. Certain Exchange conditions must be met as to kind, quality and quantity of commodity specified in the futures contract, also as to lo-

[32] ©1960 Mimir Publishers, Inc. HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS cation, accessibility, and suitability for warehousing and de livery purposes. Thus in time laws have been enacted for control over im portant operations of futures grain exchanges — the inspec tion of grain, the warehousing authority and the functions controlled by the Commodity Exchange Authority under the Act. Railroads operate under the state commerce laws and the Interstate Commerce Commission. They and other kinds of transportation for commodities affect the trading of those using the futures markets. The accessibility of these conveyances to markets for both incoming and outgoing movements, as well as rates for the commodities traded on futures markets, are very important to the kind of rules that can be written. Transportation rates from origins of the commodities to the futures delivery points and to the desti nations after delivery is taken must be carefully considered. For that reason there must be continual awareness of pro posed changes that will affect the market, and efforts made to protect the best interests of the trade. Even though there are many statutory laws there still rests a great deal of authority with the exchanges themselves. Some of the contracts in futures markets do not require the ware housing of the commodity traded in. The contract itself, however, stipulates that loading of the commodity shall be made upon the surrender of the title which by contract re quires shipment under specific conditions. Shipping orders may be deferred for an indefinite time on such contracts but holder of the contract is required to pay a premium for de ferment. Other contracts necessitate that the buyer ship the commodity promptly upon payment for title, having no op tion of deferment. The Chicago Exchange under its charter may constitute

[33] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR and appoint Committees of Reference and Arbitration, and Committees of Appeals for settlement of matters voluntarily submitted by members or non-members of the Association whose awards may be filed with the Courts for execution of judgment. The Exchange under its authority has set up various departments for the conduct of exchange affairs. The departments are under the supervision of Member Com mittees with at least one director serving on the committee. The Business Conduct Committee, including a Clearing House official as a member, may invite a representative of the C.E.A. to attend any and all its meetings. They are charged, among many other duties, with the authority to prevent manipulation of prices and the cornering of any commodity. Special committees may be appointed to con duct investigations, and if they decide to do so they may pre fer charges to the Board of Directors. The rules of the Exchange prescribe hours, locations, and conditions for trading in futures. Minimum futures com missions are stated; also brokerage rates for pit transactions. The grades of grain and other commodities deliverable on futures contracts are set by vote of the membership as well as the method of tender, delivery and payment for exchange of title. It is well established that the rules governing futures trad ing must be fundamental to the production, delivery, ship ping and uses of the particular commodity and to keep their application within strict confines, yet general enough to rep resent the commodity as a whole and not only a segment. Fu tures must represent the main body upon which particular segments of the commodity and trade in them depend. The quality factors and value as to locations of the commodity, of necessity, will differ and continually change their relation ships with the futures market, yet are dependent upon the

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS futures price as a base. Financing of commodities to be de livered on futures contracts and bank credit for financing after delivery is taken and while title is being held must be readily available to any users of the futures market with only reasonable bank margin requirements. The form of title to the commodity, whether warehouse receipt or ship ping order, must be firmly established with the banks. In instituting a futures market — first there must be a need for it after the commodity has been in production a sufficient length of time to prove its continuance and ac ceptance. A general trade should have been conducted in an unregulated forward delivery market, which however is likely to continue despite the availability of the regulated futures market. Even though the commodity may have gone through a manufacturing or conversion process, it should not be controlled by concentrated interests, either in its production or uses. It should continue in surplus for a pe riod of time and preferably there should be a surplus stock at the end of the season, either in its deliverable form or as the raw material from which the deliverable quality is de rived. If there are variable qualities of the commodity, sev eral should qualify for delivery on the contract at normal commercial price differentials. Dissemination of quotations is important and adequate trading facilities will aid in the market's development. These two will quickly follow if the trading rules are wisely set up. In markets, and more so in futures markets, prices con stantly change and act to keep production and consumption in balance. The only "fair price" as stated by Professor James A. Boyle many years ago is the "equilibrium price" which coordinates production and consumption. This is the price which moves the whole crop into consumption with out a shortage and without a carryover. This fact has been [35] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

entirely overlooked by most of our legislators and the ad ministrators who have advised the lawmakers on farm prod ucts supports. Actually they seem to have had in mind the sociological aspects of agricultural life rather than the econo mics. Despite their viewpoints and the laws that they have enacted, it has been the free cash markets and the futures markets, even though handicapped by the price support laws, that have guided the grain through the trade channels from farmers to consumers. The equilibrium price has func tioned. Each season's production over and above annual re quirements of the product has gone from the producers to the government even though some of the demand has been filled from the government's stocks and deprived the farmers of this portion. Except for a few years during the present type of price support laws, futures markets have not been called upon to carry hedges on the full harvest movement and the stored surplus until it has been required for use. The exception has been when production was small relative to requirements and prices were higher than support levels. This cannot be termed a shortcoming of futures markets, but rather proves their ability to adjust to conditions and be available for use when called upon. Even before crops are planted, futures are the guide as to prices that farmers will obtain for their grain after it is har vested. Trading about a year ahead of contract maturity, the deferred futures months reflect the dominant influences whether arbitrarily supported by government or free market values. The prices may be based upon the spot market with carrying charges when free supplies are large in proportion to the demand. When current supplies are small, but a new crop is coming in, futures prices on the old crop will be at a premium over new crop prices, and there is an inverse mar ket. Inverses gauge the distribution of limited supplies and

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS bring to market grain previously held by those unwilling to sell. Hedges placed against grain coming from country loca tions may be retained while the grain is in storage or moved to other locations for more advantageous sale. A grain in a location common to its growth follows the fluctuations of the futures market located in that area — spring wheat, Min neapolis — southwestern hard winter, Kansas City, and soft red wheat and Central States hard wheat, Chicago; corn and oats, Chicago. Soybeans, while following the Chicago fu tures market are strongly influenced by conditions in central Illinois, a large producing and processing area. Because all phases of the grain trade use the system of fu tures trading in their transactions, it is a conveyance of price from the time farmers sell their crops until consumers buy the products. In studies of open interest in wheat futures for average of semi-monthly periods in 1948, also 1949-50, and 1950-51 for large traders (those reporting their positions to the C.E.A.), after the elimination of spreading positions, the combined long and short hedging positions were from 75 to 84 per cent of the total of these traders' commitments. At a recent date July 31, 1959 the percentage was 85. This relative per cent of the total shows a uniform use of futures for hedging pur poses. Speculative combined long and short percentage po sitions also do not vary much. There seems to be a natural attraction to the use of futures by different classes of in terests in consistent proportions of the total. The total it self changes with the amount of free grain moving through trade channels. The open interest total is smaller toward the end of the season and starts to expand prior to harvest when purchases of the grain or other commodity are made for new crop movement and it reaches a peak after harvest.

Volume of trade does not follow the expansion and con traction of open interest. It is likely to follow the type of news — enlarging with news (whether economic or political) of an exciting nature, but also at times because of large com mercial dealings, and contracting when the news is dull. While we can attest to the fact that the legal status of fu tures trading is clearly defined by laws, and its legality con firmed in the United States Supreme Court in the decision of Justice Oliver Wendell Holmes in 1906 and subsequent decisions, we can more plainly see that these laws followed the course of development in commercial handling of the expanding agricultural production in this country.

Historical Evaluation, Theory, and Legal Status John W. Sharp Bakken's paper is an extensive and extremely complete review of the historical and legal sequences that were sig nificant in the development of our commodity exchanges as we know them today. In reviewing the multitude of pub lished materials on the historical establishment of the futures market, Bakken has wisely chosen a selection of materials that present the important phases of market development. It appears evident, at this point, to admit the degree of infancy of our present marketing structure. In terms of the his torical period covered in Bakken's paper, one would consider the "laissez faire" philosophy of the market a recent innova tion. However, it was at this point in his historical synopsis that the legal problems of a market structure take form. It is no coincidence that these problems arose out of the accel erated growth of our marketing system due to the introduc tion of the industrial revolution. In addition to the ethical and social barriers that Bakken outlined which seemed to impede the smooth operation of a marketing system, one must not overlook the parallel ex pansion of the market with improved technology of produc tion. Markets developed out of need — through the inter dependence of man — these needs were created by producer surpluses and these surpluses were created by the increas ing productivity and specialization of the worker. Through out history, the development of markets has been closely allied with great technological changes in the production of our agricultural products. The invention of the wheel, the moldboard plow, the tractor, along with significant improve ments in transportation, storage and communication created the need and the means for a more efficient marketing system. [39] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

The significant problems involved in the establishment of our commodity exchanges more commonly involve problems of a functional or facilitating nature, such as storage, transpor tation, communication, grading, standardization and financ ing. The determination of price, at the market place, where time and possession utility were involved, centered around the ethical and social desirability of the uses of these facilitat ing functions. The more complex we found our market struc ture, the greater the need for a legal framework under which operations could be executed.

The legal developments, as outlined by Bakken, were a result of the imperfections of the commodity markets to ac complish their function in the best interest of the people on the floor. Exchanges are created by people and people make the exchanges. Yet the bulk of legislation and legal compromise affecting the operations of exchanges have been instituted by people. It is here that many of these legal ac tions conflict with the desires and wishes of the membership primarily due to the difference in the intensity of the profit motive. Legislation does not result in a dictatorial process of the methods of operation, or "how to do the job", but does describe and enforce those actions under which an ex change cannot operate. In addition to the various facets of public opinion, as expressed in government regulation, the exchanges have enjoyed the advantage of their own power ful enforcement arm. In most instances, history informs us of a greater degree of policing from within the exchange than has resulted from the actions of the courts on the ex change membership. It has been evident from our history that these actions met with the approval of the majority of the ex change membership.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS has stressed the inclusion of the word "intent" into the market transaction, especially those actions of futures markets. It has become evident that such a distinction in our laws serves no special purposes, particularly when the law is so broadly interpreted that financial settlements of contracts are re garded as effective deliveries. Thus, we must rely on such criteria as Bakken has outlined in determining the validity of futures contracts and on these principles the commodity ex changes must operate. The responsibility and the effect of these criteria on other areas of the market and market organization should be the obligation of the exchange. It is not important to take issue with Professor Bakken's institutional approach as opposed to the functional approach because this is not important to the marketing problem. Functions of marketing have remained static in classifi cations since the beginning of the most simple market struc ture. The institutions that developed as a result of these more complex functions have changed in structure and pur pose and undoubtedly will continue to do so over time. Since these institutions change their operational nature so rapidly it becomes increasingly important that we constantly re-evaluate their objectives. The activities of a commodity exchange as an institution is a part of a function of market ing and these activities are so interdependent on other func tions that operations could not survive without storage, trans portation, etc., operating as a unit. The important developments in the recent history of the market have resulted from the intervention of marketing trained personnel into the fields of storage, transportation, grading, financing, etc., and it is increasingly important that history repeat itself on this score. Whether these mar- Mi] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR keting trained personnel have engaged in activities con cerned with the institution or the function is not important as long as the division has a clean-cut line of activity. From the evaluation of the historical and legal develop ment of our commodity markets, I would conclude that the burden of responsibility for market organization along the lines of futures trading rests with the exchanges them selves. How efficiently and economically their function is performed in the marketing process will determine the ex tent of their existence. The main objective must be to facil itate those functions upon which these exchanges depend for their existence.

Historical Evaluation, Theory, and Legal Status John D. Black My traditional-personal way of thinking about Professor Bakken's history of the evolution of futures trading is to consider it as an account of the evolution of a "social inven tion." Lest some in the room do not know what is meant by the term "social invention," I shall illustrate by naming a varied list of them: money as a medium of exchange, credit, commercial banks, corporations, Rochdale-type cooperatives, the collective farms of the Soviet Union, the communes of Red China, property rights, civil rights, laws, courts, trial by jury, representative or republican government, bicam eral legislatures, labor unions, public schools, baseball, league baseball. These have come into being out of social processes — have evolved by social action. Rarely has one individual or a group of them had a major hand even in the origin and early evolution of such social inventions. The invention of constitutional government in the United States is as good a major example as can be named of concerted group ac tion in initiating a social invention. Not all social inventions persist indefinitely. In fact, many of the foregoing list have replaced earlier social inventions — as civil and property rights have replaced serfdom and human slavery, and representative government has replaced feudalis- tic and monarchial government. The human part of the progress of civilization has consisted in large part of this replacement process, plus creating other social inventions, plus the evolving of old ones, all in the direction of a set of inventions more and more in line with the changing ideas and ideals of society. Any new social invention, or revision of, or addition to, an existing one, is on trial from the moment it is made, as was federal prohibition from 1919 on, the Federal Farm

FUTURES TRADING SEMINAR

Board program in 1929-33, the river valley authority pro gram beginning with the TVA in 1933, and the Taft-Hartley Act beginning in 1947. Professor Bakken's review and evaluation of the evolution of the world and the nation's marketing system, and in par ticular of the futures trading part of it, is very well done. It states very specifically the steps in the evolution and the trials encountered at each step. The most interesting of these trials was the court's ruling in 1852 against transactions in futures with no intent to deliver, which of course ruled out the possibility of the real function of the futures market, which is to take over the burden of bearing the risk of price changes, and especially his explanation of how the economic forces derived from the needs of the market and the economy in effect overruled the judges from 1885 on if not partly in effect earlier. At this point, I would like to qualify somewhat one of Professor Bakken's early paragraphs, which reads as follows: "Our innovators of social and economic institutions, how ever, never seem to exceed the 'bonds of immediate needs.' This is so, perhaps, because our kind of society offers so little incentive to those who perform above and beyond the call of duty. Those who venture beyond these limits run the chance of acquiring a sobriquet such as 'crackpot' or 'Don Quixote.' Another cultural block to progress may be the dif ficulty of inducing their pragmatic contemporaries to adopt new procedures before they are forced upon them by in ternal or external circumstances." This statement fits commodity exchanges and especially futures trading, better than many other social inventions — better than, for example, the public school system, representa tive government, trial by jury, the Rochdale cooperative. It is true, as Bakken carefully outlines, that pressures from pro-

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS ducer and other outside interests, on the one hand, and on the other, restrictions imposed by laws and other institu tions, did force those who were concerned with futures trading to evolve it in certain directions in order to preserve it. But there was even in this case usually some choice, and ideas and conceptions of individuals and groups with motiva tions too narrowly and selfishly defined by Bakken's state ment played a considerable part in the choices made. This is particularly important for the future of futures trading, to be discussed in later papers. Bakken himself, in spite of the foregoing paragraph, expects to see futures trading expand and develop, even eventually to be used in trading in "a great volume of manufactured products." This will not happen if nothing more than "the force of internal and external circumstances" has a part in the future evolu tion of this social invention. Bakken himself calls for a much expanded program of research and analysis of how future trading works, and of the relation of prices in futures and spot markets, the results of this to give direction to fu ture developments. In the past as in the future, though probably less so, the social invention futures trading has owed its evolution in part to ideas and motivations as well as to the pressures of circumstances. There was usually an interest on the part of a considerable group in at least preserving it but usually also in improving the futures market as it then was. If this were not true, futures trading would have ceased long since, because it has two powerful obstacles to overcome. One of these is that whenever prices of a product that has a futures market drop sharply, the producers are pretty sure to blame this on the traders. The other is that, especially in the smaller and newer markets, it is often possible for a small number of traders with short-run greedy interests to [45] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR stampede the market to serve these ends. No doubt circum stances like this have played their part in the behavior of the potato and onion markets and attacks on these as reported by Roger Gray in his recent Journal of Farm Economics ar ticle. These, according to Gray, as no doubt he will explain later on this program, need more futures trading than less. Of pertinence in this connection is the divergence between two schools of thought in present-day social science, that was first clearly delineated by the German sociologist Tonnies in his book "Gemeinshaft und Gesellschaft." Those in the Gemeinshaft school believe that society is improved most by making individuals into better human beings with finer aspi rations for society; those in the Gesellschaft school look more to social invention to build a better world. The first school has been represented at Harvard by Professor Pitirim Sorokin and his followers. Sorokin in his retirement is now director of an "Institute of Creative Altruism." The second school has been led at Harvard by Professor Talcott Parsons, author of the renowned book "The Structure of Social Action," who became head of our Department of Social Relations when it was organized twelve years ago by amalgamating Sociology, Social Psychology, and Social Anthropology. Almost needless to state, no advance in human and social well-being has been due to either all one or all the other of these. Without some of the first, this conference on futures trading would never have been called, and we would not be gathered here today concerning ourselves with the lines and directions which futures trading is likely to take in becoming a better aid to orderly marketing, consumption, and production. But still, futures trading is a social invention and, as such, we need to focus effort on making it specifically a better social instru ment. Furthermore, it must be fitted into not the economic or- [46] ©1960 Mimir Publishers, Inc.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS der that was, but to that which is evolving. To be specific, if more of agricultural production is going to be on a con tract or specification basis, the futures market needs to find its normal role in this. It is to matters of this sort that much of the rest of this program is devoted. No baptised economist can of course think of the futures market without calling to mind Marshall's concept of a "perfect" market, a market in which all traders have full knowledge of the product and its supply and demand. A perfect futures market is of course impossible because its prices are "anticipatory," to use Holbrook Working's phrase, and foreseeable only within vague limits. But this does not mean that headway cannot be made in making futures mar kets less imperfect in this respect, and this is one of the lines that should be followed in making futures trading a more useful instrument. Let me conclude by saying that the goal in further evolu tion of the social invention future trading is to make pos sible a more dependable set of futures prices for more com modities, these to serve as a basis for hedging and in general putting production, marketing and consumption in a less uncertain and less instable state. Or put in the language of Professor Frank W. Taussig's 1921 Quarterly Journal of Eco nomics article "Is Market Price Determinate?", to narrow the penumbra of darkness on the two sides of what would be "per fect" futures prices. Improving futures trading is of course not the only means of the foregoing ends. Government may even find itself playing a part in their attainment — through some such device, for example, as forward pricing. But whatever devices are used, they need to be carefully integrated with one another. And it is difficult to conceive of a set of these fitting into American capitalism that does not include a large role for trading in

FUTURES TRADING SEMINAR futures. I shall add finally that few social inventions make their way onward and upward in this society of ours without interven tion or aid of government. What Bakken has outlined in the evolution of futures trading in his section on the legal aspects of futures trading fits pretty well into the usual pattern. What is needed most of all is legal definition fitting the functioning of the new into that already existing. The courts alone may be able to do this, but ordinarily legisla tion is also needed. What I am saying is well exemplified today in the evolution of labor unions. They also exemplify another reason that legal action may be necessary, to prevent abusive use of the new social invention. Futures trading has surely contributed a sufficient quota of such abusive use in the past. By way of summary, it can be said that futures trading as a social invention is still, like most other social inventions, in the process of evolving. Extending it to new products is only part of this evolution. More important is fitting it better into our economic system and making futures prices serve better as a base for planning future production and marketing operations. This calls for fuller reporting of cur rent changes that affect prices, but much more importantly, a better understanding of the forces that determine prices in the future and how these operate to change prices. More speculative buying and selling of futures will improve fu ture prices rather than unstabilize them, only if it is based on a fuller knowledge of market conditions and better un derstanding of how the market for the commodity operates. Any futures market for another product that is set up is likely to have rather difficult times in its early years just because this needed knowledge and understanding has not yet come to be.

Historical Evaluation, Theory, and Legal Status Discussion MILLER: Professor Bakken has waived his right to rebut tal, so we are ready to take questions from the floor. They can be addressed to the chair or to any one of the panel that is here. Mr. Schonberg unfortunately had to leave. HIERONYMUS: I note, Professor Bakken, your statement, "It is thought by most people that these markets are inex tricably bound together by the right of delivery," and you implied that you can have a futures market that does not involve delivery. I wonder if you can expand on this and explain how this is reasonably possible. BAKKEN: Yes, not only do I imply this, but I have posi tively stated that the cash and the futures markets are two severable and independent markets each designed to per form distinct specialized functions. Market organization has evolved through at least five stages, three of which we may illustrate in the following manner: Stage 3 Stage 4 Stage 5 Spot or cash markets Based on contracts for delivery Futures markets (first (came into existence of a specific good or a delayed recorded use Japan, with the invention of payment or both after a lapse 1697 and legalized a medium of exchange) of time. Such contracts are cus- 1730; England, 1826; tomarily referred to as: "con- and in the U. S. 1867) tract to arrive" and "contract of sale," etc., in modern markets (evolved in medieval times) The cash or spot market eventually became inadequate to clear trade and a more efficient procedure of transferring rights and titles to goods and properties had to be contrived. Traders began making contracts for specific lots of goods to be delivered sometime in the immediate future. The use of "to arrive" contracts was found to be exceedingly use ful and necessary, but as time passed even such contracts proved inadequate and eventually trading in futures was [49] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR conceived under the lash of necessity. The traders proceeded from an attitude of subjectivity to one of objectivity. Through out this progression in market organization the contracts con tinued to be tied to specific commodities such as corn, cot ton, and cocoa. I claim that when we reach a complete state of objectivity you can operate in a futures market without reference to delivery and we are approaching that point now, for example, in wheat. I understand a very small percentage of the total number of transactions in the futures market is actually de livered in physical form. You have in this commodity and others a very tenuous tie between the two markets. We can, in my opinion, continue to perfect the futures contract. The cash market performs certain definite func tions and the futures market in like manner is designed to perform certain functions. The two need not be tied to gether by an antiquated concept of delivery. If one market strays far out from the point of reality, the other market will take effect and will become the ruling market. At the present time I regard the futures market as the dominant market in setting prices. The spot market is an institution in which one gets delivery of a specific good. The spot market is actually the culmination of a series of transac tions which take place on the futures market, but it is not necessary to mature the contracts by physical delivery. The more efficient means is to cancel the contract by an opposite commitment and be free to enter the spot market. There one can fill his needs in a more precise manner. It is even possible, in my way of thinking, to conceive of a universal contract rather than to have many commodity contracts tied to specific commodities. Under this concept, one would really engage in trading on the bases of index num bers. [50] ©1960 Mimir Publishers, Inc.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

FLOOR: But what will be the function of your futures mar ket? BAKKEN: Its function is that of pricing. FLOOR: Pricing of the universal commodity which has no tie to reality or business conditions? BAKKEN: While details of such trading still remain to be perfected one need not, I believe, depart from reality. We can have a standard contract which will establish base prices. The various commodities will each have an established dif ferential ranging up and down from the key or base price. The function of the cash market is to establish the pre miums and discounts over or under this base price. That is what takes place now on any exchange having both spot and futures markets. If you ask the traders at the cash tables whether the futures traders ever come over and con sult them as to what prices should be, they will tell you they never show up. The people at the cash tables, however, never make a price without reference to the current futures price. FLOOR: Sure, but only because they are inter-related, only because we know that we can deliver if necessary or we can demand delivery, if necessary. BAKKEN: You see, I am claiming that this is only the vestigial remains of subjectivity. Traders appear to simply con stantly think in terms of wheat or cotton or coffee and so on. I don't think it is necessary. You are really actually trading in rights, titles, and privi leges to goods, services or properties. HIERONYMUS: But you have to have a right for a title to something. Now, suppose you're long December wheat, you know what you have a right in, but only if you can de mand it. With a universal contract, what would you have the price of? [51] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

BAKKEN: I call your attention to the fact that in a futures market one only acquires an equitable right, not a specific right. So one cannot force specific delivery in a futures trans action. The sellers can settle by paying the buyer cash rather than delivering the product. The court has already made that decision. SCHRUBEN: Do you regard hedging as essential to fu tures trading? BAKKEN: Not at all. I tried to make that point clear in my paper. Hedging is incidental to futures trading, and I believe we can look at the stock market as an illustration. To what extent does hedging take place in the stock market? Not to any great extent. They are trading in rights and titles to goods and properties in the stock market. The stock market is a very vital institution and I believe the commodity exchanges could be just as vital without the function of hedging. You see, my point is this, when a man hedges, he sheds any risks that he may have from price variations. In a hedge he assumes the position of zero ownership. He makes a commit ment in the cash market and he offsets that commit ment on the futures market with an opposite transaction. This results in a position of zero ownership if the two quan tities, one on each side of the transactions are equal. He cre ates no net possession utility. It is only the speculator that does, and my feeling is that Baer and Saxon as well as others have overstressed the hedging function of marketing and they have neglected to point out the real function of a fu tures market. JONES: Mr. Bakken, who assumes the risk on the cash trade? BAKKEN: The individuals that make the commitment to buy, whenever they assume an open position in the market. [52] ©1960 Mimir Publishers, Inc.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

JONES: If, for instance, I wish to buy fifty thousand bushels of a certain type and quality of grain, what do I do under your thesis? I am just standing there as a speculator. BAKKEN: Certainly if you buy the grain. JONES: Until such time as I protect myself by selling a futures contract. BAKKEN: That is right. Then you take a position of zero ownership. You are a speculator in either the cash or futures markets whenever you take a position without assuming an opposite position by a counter transaction in another market. This is the trouble with the cash market, it is too specula tive for the individuals that have to carry the risk. JONES: What I am getting at is this: I know from experi ence that in practically every instance in which a cash pur chase was made, a futures contract was made against it. BAKKEN: But what does that prove? That simply means that you have two markets and you utilize them to the full extent to protect yourself. JONES: Until such time you want to make the final sale of the cash article, then you buy back the future. BAKKEN: I am not arguing against the function of hedg ing, I think it is a wonderful device, but I say it is not neces sary to the existence of a futures market. JONES: Well, I don't know what you would have; what you would use the futures contract for. The largest percent age of the business done in futures contracts is for hedging. BAKKEN: I believe that C.E.A. reports reveal that only one-third to one-tenth of the transactions are classed as hedg es. In the stock exchanges there are no hedges. JONES: That is a stock market. There is no futures contract. BAKKEN: I disagree. Stocks and shares represent incor-

[53] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR poreal properties, not corporeal properties. The stock mar ket is not a spot market in the strictest sense of the word. JONES: That may be true, but is cash wheat not tangible? BAKKEN: Yes, but the futures market is actually not deal ing in tangibles, it is dealing in incorporeal goods. JONES: You just buy a future contract and sit and wait and you will get a solid tangible when it is delivered to you. BAKKEN: That is right. A transaction can be materialized in such a manner. That is the vestigial feature that we now have where the two markets are tied together. For sake of argument, I think I can say that we can sever the Gordian knot. You can cut these two markets loose and let them run their course and perform their independent functions. SCHRUBEN: Do you have an example of the existence of futures market where that is true? You cite the stock ex change, but when you buy a share of an intangible you are buying a specific company or in a mutual fund, which gives you a list of the companies in which you are purchasing. BAKKEN: Historically, futures trading in grain presumably began in 1867. The practice of hedging transactions in grain was developed in the early eighties. In the forma tive years of the Board of Trade, transactions were con summated purely on a speculative basis. Currently, we have not attained much progress in this direction but I think it is going to materialize over the long pull. SCHRUBEN: So you have speculators speculating with other speculators. BAKKEN: That is right. GRAY: I will make mine brief, because I get a chance later, too. I don't think we need to do anything here for the sake of argument, we will have plenty of argument without doing things for the sake of argument, but in time you might find a consensus here that you have a very beautiful paper except [54] ©1960 Mimir Publishers, Inc.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS for two paragraphs and my question is would you consider de leting these two bad paragraphs? BAKKEN: No, I am sorry. I do not think I can back-track on that for the record, because I am already on record. In my book on the Theory of Markets this position was taken in 1953 and it has never been challenged by the reviewers. I may not succeed in convincing anyone in this group today on this point, and perhaps I am wrong, I may be totally in error in this theory of transactions. GRAY: My question really was, do you think this group might convince you in two days? BAKKEN: They might! (Laughter) SCHUMAIER: The thing I don't understand, I guess, is you say that if futures market got out of line, the cash mar ket would become dominant. BAKKEN: Correct, the cash market would become domi nant. SCHUMAIER: What would hold them together? Why not let them be deliverable. BAKKEN: If one is completely out of line with reality, it wouldn't stay there long, it will simply come back into line. They do now anyway. FLOOR: But why, if no delivery is possible? BAKKEN: Because it will attract no business if it deviates too sharply from reality. KENDALL: I sort of deserted the academic and therefore maybe this is why I find myself on Professor Bakken's side. I just want him to know there is one person that agrees with the points that he makes. You know, the theory of speculation as far as commodity exchange is concerned was probably developed, practically speaking, in the stage that [55] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR we know it today, in 1896 in a book by a man named Emery. He was a professor at Columbia. Everybody has repeated this same analysis, the reason why we have this hedging, the tying of the two markets together in their mind, and the Board of Trade has gone to Congress hundreds of times and explained the same idea. I have always thought that there was another way and I think the professor here is on the threshold of a new way to look at this phenomenon. A view that some day the Board of Trade will use to do a better job of convincing the folks in Washington as to why they should exist than the hedging argument which has been the number one argument until this time. I give you nothing but moral support at this moment, professor. (Laughter) RIES: Professor Bakken's theory seems to have merit when we examine the time element involved in the so-called cash market. On the cash side we see time as a flow; that is, we expect to see trading every day in the ownership of a present physical commodity. When a futures is set up, one of its features is the time limit placed around it. Here we make the categorical state ment of time lapse. This time difference in defining the two markets, in my opinion, makes them independent one from the other. The two markets tend to become one only for a very brief instant of time. Knowingly or unknowingly we admit to the inde pendence of each, for as we approach delivery in the previous ly indefinite futures market, new futures are set up which seem to me to be an acknowledgement that Professor Bakken's theory is correct. BROOKS: You say hedging is not the prime function, but speculation is, is that right? [56] ©1960 Mimir Publishers, Inc.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS

BAKKEN: Yes, the function of the futures market is pric ing, that of establishing base prices, that is its major function. GOLDSCHMIDT: I just wanted to get the practical point of view across. In the grain company like ours, we actually make our trading profit in trying to be students between the cash market and the futures market, on what we call the basis. If there were no relationship between the two, I don't think businesses like ours could exist. As you have said, to operate in a cash grain market is too speculative, as it is. Consequently, I think you must agree that there are some economies that are being had by the opportunities of hedging. When we hedge and use the futures, the future is only a hedge if it has some relation to the cash in which we deal. If there is no relation, there obviously is no hedge. Now, I don't know how you would devise a better system than this particular one. BAKKEN: I do not disagree with you wholly. I did not say there wasn't a connection between the two. I do say, however, they are independent entities. They are compli mentary and they supplement each other. One market per forms one function and the other performs a different func tion but the two can be related. A person can operate in both markets, but he does not achieve the same thing in the two markets. GOLDSCHMIDT: We know that. BENDEL: I would like to venture an impression that I have, if I may. Wouldn't we be able to compare perhaps in three ways a futures market relationship to cash market, in the way of an insurance program whereby Lloyds of London evaluates cargos and ships but they never deliver cargos and ships when there are claims. In the cash physical market there are perhaps careless opinions expressed which might affect goods evaluation, but [57] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR in a futures market people in effect put their money where their mouth is. It is professional opinion, and it acts I think as an insurance that the physical market picture is correct, as automobile insurance. You would not expect automobile production people or automobile operators to be tied in with the automobile insurance people. Yet they both exist. Would this be a reasonable comparison? There is a re lationship but there is no physical tie. BAKKEN: There need not be a physical tie, that is my point. In other words, the court has already said you don't have to deliver, you can settle the difference in cash, which is purchasing power. PAUL: I will be on the program later, but I feel compelled to make an observation and ask a question at this point. I applaud Professor Bakken's effort to move thinking on futures trading away from exclusive attention to the hedg ing role. I will have more to say on that, but I think he goes off the "deep end" by doing away with hedging. On the point that Mr. Schruben raised, I think we can point to an example of futures trading "without delivery," which died because the laws required it to die back in early Illinois history, I mean the bucket-shops or whatever they were. Bucket shops arise when we go in the direction Bakken is trying to lead us. Yet I say I applaud his effort to advance what I think is an essentially correct explanation of futures trading. But the explanation is a limited one. It arises from a point of view about the individual and how he deals with his business problems. If he feels risk, he feels a need to do something about it and he locates someone who wants to take the opposite side of a transaction and therefore we have an explanation, a systematic explanation, of futures trading, which is truth as far as common requirements of that truth are. That is, for explaining his actions it may be [58] ©1960 Mimir Publishers, Inc.

HISTORICAL EVALUATION, THEORY, AND LEGAL STATUS all right, but extended to explain how the system accepts futures trading, where it works in with the system, what the future is, it has limits. The point I would like to ask Professor Bakken about on his historical survey is a point I don't find in his paper. It is on the role of the goldsmiths in early banking which is very intriguing. Do I understand you to say that the fear of being robbed by highwaymen was the cause of deposits by the merchants of their gold and silver and that they received evidence of deposits which was used in exchange? Then can we go farther, and this is not in your paper, and look at the significance of the development in banking where more claims were issued than there was gold on deposit? What the goldsmiths did was to sell some of the gold they did not own, but could always repurchase, because the demands for use of that gold were very limited. It is just another step to say that they over-issued warehouse receipts on gold, which is the essential feature of a modern banking system. BAKKEN: That is right. PAUL: In other words, a structure of debt, with gold being the means of paying that debt, became erected on a small base. BAKKEN: This is precisely the discovery they made. Now, may I make one or two comments? I do not want to leave the impression that it is my desire to do away with hedging. That is the furthest from my thought, and I am not recom mending, as Paul contends, spurious trading and bucket shop transactions. The type of transaction I am suggest ing is based on a universal contract open and above board in market overt where the quotations are made public. If such transactions are bona fide contracts made under rules of the exchange they cannot constitute a bucket shop opera tion. [59] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR YODER: If nobody wanted to hedge what would be the function of the futures market? BAKKEN: Well, the hedging operation only takes up a small part of the total transactions of the exchange, so the doctors, lawyers, and professors that want to plunge in the market can still take a long or short position which is speculative and they will find other people I am sure who will trade with them on a speculative basis.

Part 2

THE IMPORTANCE OF HEDGING IN FUTURES TRADING; AND THE EFFECTIVENESS OF FUTURES TRADING FOR HEDGING Roger W. Gray

TiH E reason why the lengthy and almost redundant title for this paper seemed necessary is that evidence bearing on the two parts is treated quite dif ferently. On the first part — the importance of hedging in futures trading — the effort is to briefly review kinds of evi dence that have long been available. On the second part — the effectiveness of futures trading for hedging — a particular piece of new evidence is emphasized. This difference in treatment is necessitated by the futility, on the one hand, of attempting to treat the evidence of the importance of hedg ing exhaustively in so brief a presentation; and, on the other hand, by the paucity of direct evidence on the effectiveness of futures trading for hedging. One would find too much to say on the first topic, too little to say on the second; so the compromise is to discuss them both.

The Importance of Hedging The importance of hedging is best expressed in the cate gorical statement that futures trading depends upon hedg ing. Evidence of this dependence abounds in the statistics of commodity markets, and the habitue of the markets comes against such a constant stream of first-hand evidence that he takes the relationship for granted. Study the open interest

FUTURES TRADING SEMINAR

in any commodity-futures contract and you obtain insight into the economics of the commodity, so strong and general is the relationship. Find two commodities for which the open- interest pattern differs markedly and consistently and you will find that their production or distribution differs in such a way as to account for the contrasting open-interest patterns. Consider, for instance, a contrast between two very impor tant commodity futures markets, those for wheat and corn at Chicago. The open interest in wheat had a much wider seasonal range than that in corn during the 1920's and 1930's when both markets were thriving. The cause of this lay in the contrasting commercial movement, wheat being mar keted rapidly, corn being marketed over a more prolonged period owing to slower harvesting techniques plus the fact that it need not be harvested rapidly and the consideration that crib storage was a good drying method. The greater seasonal concentration in movement of wheat made for great er seasonal concentration in its hedging and hence in the open interest. Similarly, the average level of open interest in wheat was much larger than that in corn, for the reason that wheat had a greater commercial movement although corn was produced in much larger quantity. These are familiar facts, but the evidence they provide of the importance of hedging in futures trading bears continued emphasis. In these and many similar cases it is quite clear that the pattern of the open interest is dictated by the hedging use of the market. Nothing on the speculative side, that did not arise out of hedging business, could explain these use patterns. For a large number of commodities the open interest in futures, in its seasonal and year-to-year fluctuations, follows closely the commercial stocks or visible-supplies data. This generalization of the above cases is the strongest single class of evidence of the dependence of futures trading upon hedg-

IMPORTANCE AND EFFECTIVENESS OF HEDGING ing. Even in markets where large proportions of the com mercial stocks are not hedged, the minor fraction that is hedged characteristically dictates the pattern of open interest. If it is not stock carrying it may be the hedging needs of certain processors that dictate the level of open interest. Thus, for example, the open-interest pattern in soybean oil or in millfeeds has not typically conformed to the stocks pat tern. Investigation of the hedging policy and practice of users of these contracts soon reveals that they are used for purposes other than stock carrying, however, and that the open interest still conforms to hedging use. Or it may be the financing of a growing crop rather than stock carrying which gives rise to hedging, as in the case of onions and po tatoes; or the financing of imports, as in the case of coffee and cocoa; and in these cases as well it is hedging which dic tates the open-interest pattern. In addition to seasonal and year-to-year patterns, there are long-term trends as well as singular episodes reflected in the open interest which can be shown to rest upon hedging use. The long-term decline in wheat-future business at Min neapolis relative to Kansas City since about World War I reflects the changing relative importance of the two as mill ing centers. The episode which was described by Working,18 in which soft wheats became the effective delivery at Kansas City in 1953 and the millers fled the market, illustrates vivid ly the importance of hedging. Only by a change in the con tract to require a hard-wheat delivery were the hedgers per suaded to return and preserve this market from complete disuse. In sharp contrast to this singular episode which was of the market's own doing, some weighty evidence of the

importance of hedging is found on many markets today and is neither of their doing nor to their liking. I refer, of course, to the general decline in levels of business on most futures markets — a decline which stems primarily and directly from the reduced need for hedging occasioned by the extensive stock-carrying engaged in by an agency of the federal gov ernment. Recent increases in business owing to the sub sidy-in-kind program provide additional evidence that it is the demand for hedging which determines the level of use of futures markets. Evidence on this score, as suggested earlier, proliferates. I have sought merely to indicate the kinds and sources of available evidence on a question on which the evidence in dicates overwhelmingly that futures trading depends upon hedging. The Relationship Between Hedging and Speculation The more difficult task, having drawn this conclusion, is to show the relationship between hedging and speculation in its bearing upon the question of the effectiveness of fu tures markets for hedging. For the inescapable conclusion which must then be drawn — that hedging depends upon speculation — shifts the emphasis to the importance of specu lation, having just established the importance of hedging. Not only are the mutually interdependent relationships dif ficult for the inexperienced to grasp, but the evidence of the dependence of hedging upon speculation is not so easily marshalled. In consequence it is, I believe, this arc of the circle which needs most attention from those who would attempt to round out the general understanding of the role of futures markets. Before presenting some direct evidence of the effective ness of certain futures markets for hedging, I should like to comment upon the general relationship between hedging

[64] ©1960 Mimir Publishers, Inc. IMPORTANCE AND EFFECTIVENESS OF HEDGING and speculation, orienting the commentary upon the data shown in the accompanying table. These data are of a sort readily available for many commodity-futures markets, selected here for illustrative purposes from four leading com modities which have highly developed futures markets. With out purporting to raise all of the questions suggested by this brief tabulation or to fully answer those raised, I next call your attention to some obvious comparisons and suggest some reasons for these.

Table I Percentage Composition of the Open Interest in Selected Commodity Futures; All Contract Markets Combined, 1948-58* Small-scale Large-scale positions repo rted as Commodity positions Specul ation Spreading Hedging Long Short Long Short Long Short Long Short Wheat 48.0 33.1 11.0 4.6 20.1 20.1 20.9 42.2 Corn 54.8 34.9 16.9 5.9 16.1 16.1 12.2 43.1 Oats 73.9 33.1 10.7 4.0 12.9 17.3 2.5 45.6 Soybeans 52.8 44.1 8.0 7.1 25.4 25.4 13.8 23.4 *Years are July-June, 1948-49 through 1957-58, excepting for soybeans, for which only the last five years were taken owing to the sharp upward trend in the data during the first five years. Data from U. S. Dept. Agr., Commod. Exch. Authority, Commodity Futures Statistics (Stat. Bui. 239, 1958). In scanning the columns under "small-scale positions," the eye stops at oats, where the percentage figures are clearly out of line with the others. The large proportion of small- scale long positions reflects the large proportion of large-scale short-hedging positions. Oats hedging is unbalanced for two reasons (1) there is little processor hedging and (2) they are an import rather than an export crop. Unbalanced hedg ing makes for unbalanced speculation; a high proportion of the small-scale long positions, being presumably speculative. Turning to the columns under "speculation" one may be struck by the seemingly large amount of speculation in corn. A comparison with wheat provides some insight here. Corn is, again, a more unbalanced hedge than wheat, for both lack so much processor hedging and so much exporting. In wheat, [65] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR in other words, substantial short hedging is offset by long hedging, with resultant diminished need for speculation. This offset would be conjectural if it were not for the unique situation that the two subsidiary markets in wheat, at Kansas City and Minneapolis, are known to be almost entirely hedging markets, relying heavily upon a Chicago spread to provide some liquidity. If Kansas City and Minneapolis data could be subtracted all the way across from the wheat totals, the result ant Chicago wheat data would conform more closely to the corn data. Even the spreading totals in the next column would be brought into line, because those for wheat are swollen by an intermarket spread which is negligible in corn. Looking further at the "spreading" columns, one finds oats have the only unbalanced spread because of the Winni peg market, and the direction of the imbalance conforms to our earlier observation regarding oats imports. This un balanced spread effectively transfers some long speculation to Winnipeg. Soybeans have the largest spreading propor tion, partly because only the last five years of the decade are shown for soybeans, and spreading trended upward during the decade. Even so, it was also the largest during these five years, and the reasons probably include (1) the fact that there has been more opportunity for a processor spread, or what may be termed spreading by hedgers, and (2) the fact that the soybean market has required and attracted more speculation and thus provided more opportunity for a tax spread. The most interesting comparison in the hedging columns has to do with the balance between long and short reported hedging, corn and especially oats being quite unbalanced while wheat and especially soybeans are more nearly balanced. The reflection of this characteristic in the speculation col umns is of interest. Between wheat and corn, as already not- tee] ©1960 Mimir Publishers, Inc. IMPORTANCE AND EFFECTIVENESS OF HEDGING ed, more speculation per unit of hedging is apparently re quired for corn, the reason being that there is less long hedg ing to offset short hedging. Yet the same reasoning would lead one to expect that oats would require still more specu lation per unit of hedging, which they apparently do not. The extraordinarily large amount of small-scale long posi tions in oats which would be mostly speculative, probably accounts for this apparent discrepancy. Soybeans, finally, appear not to fit the picture at all; for the hedging positions are most nearly balanced yet the reported speculation is a much higher proportion of reported hedging than in either wheat or oats. The reason for this is that the annual average figures used here are misleading indicators of the degree of balance in soybean hedging. The available semimonthly figures show that soybean hedging is much more out of bal ance than these figures suggest, being heavily net short during the first part of the crop year and heavily net long toward the end of the year. This is not true of the other commodities shown in the table, and it imposes particularly heavy specu lative requirements on the soybean market. When the re ported hedging position shifts from 10 million bushels net long to 16 million bushels net short in one month during which the reported long plus short hedging averages less than 40 million bushels, the market is under considerable stress. Yet for the five years shown in the table this was the average situation in soybeans for the month during which hedging went from net long to net short. This emphasis upon the responsiveness of speculation to hedging needs may seem to minimize its responsiveness to other causal factors. Undoubtedly the amount of specula tion in soybeans, relative to the amount of hedging, has been high owing to the greater speculative opportunity that has been present in this fast-growing and relatively free market.

In summary, for four commodities that have large futures markets operating under similar circumstances, the first im pression to be had from the table is one of confusion. Yet if due allowance could be made for different levels of reporting amongst these commodities, and especially for different hedg ing uses, the grossest dissimilarities in the table would be greatly modified, perhaps even to the extent that the general impression would be one of uniformity." But even suppos ing this to be the case, there are many other commodity-fu tures markets the data from which would not fit this picture of rough uniformity. The markets for these four commodities rank high in the amount of speculation relative to hedging; extending the list of commodities would soon encounter fu tures markets on which the speculative fraction is of an al together smaller order of magnitude. These four are markets having a good deal of speculation, at least relative to most futures markets; and because they have a high level of hedg ing use relative to the potential that exists in the commodity movement, there is presumption that they are effective hedg ing markets. In other futures markets, such as those for bran or coffee for example, hedging has been light relative to the full potential, and speculation light relative to actual hedg ing. The presumption arising out of light hedging use that these have been relatively ineffective hedging markets sug gests that the low level of speculation has been a detriment to effective hedging use. Observation of the quantities of hedg-

9 An illustration of how adjustment for hedging use alters the impression from one of confusion to one of uniformity is provided in Figure I. There it is shown (Section A) that the relation between total reported hedging and total reported speculation, annual averages of mid-month and month-end positions for corn and wheat, is not close for either corn or wheat and that the regression lines are much different between the two. When the relation between hedging and speculation is formulated in such a way as to take account of the different hedging use of the two markets (Section B), relating short minus long hedging to long speculation, the relationship is much closer for each and the individual regression lines are similar. [68] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING

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[69] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR ing and speculation does not lead beyond the presumption of effectiveness or ineffectiveness for hedging, however, where as direct evidence must be obtained elsewhere. It is some such direct evidence that is presented in the remainder this paper. Evidence on the Effectiveness of Futures Markets for Hedging To go beyond a presumption of effectiveness for hedging it is necessary to start talking about what it costs to hedge. There are, of course, indicia of hedging effectiveness other than costs. What it costs to hedge must be related to what the hedge accomplishes. In markets with a good deal of speculation, hedging against risk in general is made possible by the liquidity of the market; whereas in the smaller and less speculative markets, selective hedging of particular price risks is done on the basis of price judgments. Markets having less speculation are necessarily markets in which the hedging is more speculative. In what follows, I have not only limited the analysis of hedging effectiveness to consideration of costs, but I speak in terms of only one dimension of costs. Those dimensions of costs which might spring first to mind — com missions and the gap between bid and asked prices — I have ignored in approaching that cost dimension which might more precisely be termed "the expectational bias." Lest these remarks seem to place too great a qualification on what follows, I should add that I consider this the most important dimension of hedging costs, and hedging costs the most im portant indicator of market effectiveness. A market on which hedging costs are high is obviously less effective for hedging than one on which hedging costs are low. Records are not available which would make it possible to measure hedging costs precisely, specifically, and directly; hence, resort must be had to general statistical measurements. [70] ©1960 Mimir Publishers, Inc. IMPORTANCE AND EFFECTIVENESS OF HEDGING

The question which is answered statistically in the following analyses is whether the profits or losses from the long side in certain futures markets differ significantly from zero. In non-ethical terms, an attempt is made to ascertain statistically whether the market is balanced pricewise, or lopsided in favor of the long or the short side. A balanced market, one in which there are no profits or losses in the long run from maintaining a perpetual long position, is clearly an effective hedging market. I shall report the measured degree of im balance, so to speak, in various markets under various cir cumstances, in terms of a statistic known as the £-ratio. In order to better convey the meaning of these ^-ratios, let me provide an illustration in a framework familiar to most of you. Suppose you were to maintain a long position in the Chi cago wheat-futures market by routinely buying each future on the first trading day of the delivery month of the preced ing future, and selling it on the first trading day of its own delivery month. If you happened to buy, say, the May future on March 1 to start your program, when both the May and March futures were at $2.25 per bushel, and ten years later after 50 successive trades sold out the March future on March 1, when both the March and May were again at $2.25 per bushel, you would say the market was unbalanced if you made or lost much money out of this operation, but balanced if you came out nearly even. Given the pattern of wheat- price fluctuations that has prevailed in the past 10 years, an average profit of 3l/2 cents per bushel per future from such a program corresponds approximately to a £-ratio of 2.0, an average profit of 13^ cents per bushel per future to a iVratio of 1.0, and zero average profits to a f-ratio of zero. The i-ratio is a general statistic that carries meaning without regard to [71] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR the particular context; but it is no doubt clear to all from this illustration why a t-ratio in the neighborhood of 2.0 is said to be significant. In probability terms, the odds are more than 20 to 1 against such profits resulting from the play of chance alone; yet the odds are only about 4 to 1 against average profits of 1 cent per bushel per trade (correspond ing to a

0 See table II pages 74 and 75, for an excerpt from a table of distribution of t, and for details of the calculations, including prices and adjustments, if any, for price change. [72] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING than in the above four, but which provide separate bases for comparison with the above four as well as this common basis. We look first at the coffee market, the Brazilian contract on the New York Coffee and Sugar Exchange, a different market for a different commodity, over essentially the same period as the first three above: (5) Coffee "B," New York Coffee and Sugar Exchange, May 1, 1950-December 1, 1958: t = 1.788 The hypothesis of balance is rejected, along with the con clusion of effectiveness for hedging. Next we look at a different market for essentially the same commodity and time period as one previously considered, and obtain sharply contrasting results. Wheat on the Min neapolis Grain Exchange is compared with the results al ready shown for wheat on the Chicago Board of Trade: (1) Wheat, Chicago Board of Trade, December 1, 1949- March 1, 1958: f = —.116 (6) Wheat, Minneapolis Grain Exchange, May 1, 1949- May 1, 1959: t = 1.986 Results are next shown for one commodity over two separ ate periods: (7) Bran, Kansas City Board of Trade, July 1, 1947-March 1, 1952: t = 2.079 (8) Bran, Kansas City Board of Trade, July 1, 1953-De- cember 1, 1956: t = -1.827 Finally, the results shown above for soybeans are compared with results obtained for soybeans in an earlier period: (4) Soybeans, Chicago Board of Trade, May 1, 1955-July 1, 1959: t = .107 (9) Soybeans, Chicago Board of Trade, November 1, 1948- September 1, 1953: t = 2.221 The general conclusion which is supported by all of these cases is that markets with relatively high levels of specula-

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FUTURES TRADING SEMINAR tion are most effective for hedging and those with low levels of speculation are least effective for hedging. In the coffee market, the Minneapolis wheat market, and the Kansas City bran market, the amount of speculation ranges from little to negligible and the amount of hedging is a minor fraction of the potential that inheres in the volume of the respective commodity movements. Coffee importers who require a short hedge have paid a price for it, as have short hedgers in Min neapolis wheat futures. In bran, it is interesting to note that the market was first lopsided against the short side and then tipped the other way. With negligible professional specula tion, hedging in the bran market has necessarily been highly speculative. Flour mills that sought a hedge during the years of high bran prices encountered reluctant futures buy ing on the part of merchants and feed mixers. Subsequently, these same merchants and feed mixers, in seeking to hedge sales or requirements at lower prices have encountered re luctant selling by the millers. The millers reluctance finally became complete, so to speak, in that they abandoned the market. While the immediate cause of the death of this mar ket may be written in the coroner's report as the millers' de parture, the underlying cause was the poor general state of health of a market which lacks speculation. The soybean market was a relatively ineffective hedging medium during its rapid growth phase. Fortunately, hedgers were willing to support it through this phase, and they have been rewarded with an effective hedging medium as the market reached maturity. The proportion of open contracts reported as speculative was significantly lower during the growth phase than has since been the case.

The foregoing evidence is not complete in that it does not refer to all futures markets. I hasten to add that these are

IMPORTANCE AND EFFECTIVENESS OF HEDGING the only markets into which I have looked for evidence of this sort thus far, and that the evidence has as yet produced no sur prises nor setbacks for the hypothesis that, to be effective for hedging, a futures market needs much speculation. More over, incomplete as is this evidence, it does represent a variety of situations, including different commodities at the same time, the same commodities at different times, and the same commodity on different markets. Now Professor Phillips, writing to comment upon the copy of this paper that I had sent him, urged me to place this analysis in proper perspective with regard to the basis. His letter enabled me to see what I had not seen when I wrote the paper: that the results had not been presented in such a way as to relate them to ordinary usage and thinking on this subject. In consequence, the severity of the test which is here applied to futures markets might not be apparent at first glance, and some less severe tests might be urged as being considered more severe.

A common, and accurate, expression, for example, is that the hedger is concerned with the basis, being as he is an ar bitrager between cash and futures prices. Would it not there fore be appropriate, in evaluating the effectiveness of a market for hedging, to measure the basis? Indeed it has been suggested that what should be done is to measure the stability of the basis, and some earlier studies of hedging possibilities on futures markets compared the variability of the basis with the variability of cash prices. This particular form of the measurement of basis stability is a meaningless test of futures market effectiveness because it presupposes not that most hedgers are arbitragers trying to get ahead in the world, which they are, but that they are a queer sort of conservative commercial idiot striving always and only to break even.

Having in mind as I did this meaningless concept of basis stability, 1 deliberately abjured the measurement of basis stability as such, and thereby deprived myself of the realiza tion of the fact that I had indeed measured a meaningful basis characteristic that might easily be thought of as "basis sta bility." The measurements presented above in effect test whether or not the basis has an average value of zero. It is easy to see that this might be thought of as basis stability, al though I had thought of stability as connoting minimum de partures from an unspecified average value. The hedger has no right to expect and no reason to want basis stability in the latter sense. Logically the basis should vary through time, hence he has no right to expect it not to. If it did not vary, most hedgers would be technologically unemployed, hence they have no reason to want it not be. Obviously, measurement of basis stability in this sense does not test the effectiveness of a market for hedging. Moreover, since absolute invariance cannot be desired in the basis, such a test is bound to be watered down to a comparison of basis variability with cash-price variability. All futures markets mentioned here, including those that were so lopsided that they died, easily pass this test of basis stability. Indeed, such an ineffective hedging medium as the coffee-futures market would appear not only effective in such a comparison, but more effective than the Chicago wheat-futures market. In sharp contrast to measurements of the comparative variability of the basis, testing the basis for an average value of zero is a meaningful, severe, and discriminating test of the effectiveness of futures markets for hedging. Had I realized that there was advantage to be gained from expressing the results in terms of the basis, I would also have given some consideration to another matter which Professor Phillips has urged me to discuss. It is not immediately ap- [78] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING parent where the cash-price part of a basis computation is found in the present analysis. The cash-price series is carried in the futures-price series through the artifice of making all the paper transactions on the first trading day of the delivery month, i.e., the day on which, in general, the price of a fu tures contract has just become a commodity price. The basis in this analysis is the difference, on that day, between the price of the expiring future and that of the next future. The trading date is thus seen to have been chosen on economic grounds, as better than any other, rather than on the statis tical ground of not worse than any other. There are economic arguments against both earlier and later dates for such a rou tine trade — for examples, hedge switching at earlier dates and delivery-month squeezes (fairly persistent in coffee over the period considered) at later dates. The routine "trading" procedure employed here is adequate to sustain the conclu sions drawn from it; but this does not mean that further in tensive study of other price relationships would not reveal other important economic characteristics. Before summarizing my remarks, there are two related matters which deserve mention at this point. It has been convenient to speak of a futures market as though it were an inanimate mechanism with certain performance characteris tics. This is of course unrealistic. A futures market is no better than it is caused to be, by the people who regulate it and use it. Fortunately, most of the regulation is self-regula tion by the users. They are in the best position to know when a contract is becoming one-sided and needs adjustment, when hedgers are being fairly and effectively served and when they are not. A well-balanced market neither springs into being full blown, nor does it remain in being without con stant vigilance. Such markets as are maintained on the Chi cago Board of Trade are testimonials to the hard work and [79] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR dedication of many individuals. Markets which limp along or die may reflect negligence, apathy, chicanery, or lack of un derstanding on the part of those whose responsibility it is to maintain them. It is also true, however, that markets can wither and die despite the most persistant and enlightened efforts of their managers. No futures market can be an ef fective hedging medium when no hedging is being done; and certainly great reductions in hedging of numerous com modities have occurred through no fault of the markets. Some of the regulation of futures markets has been not self-regulation, but regulation by government agency created by the Congress. In general this appears to me not to have been unduly onerous, but in one particular related to the evidence shown here it appears to me ominous. The Con gress and the regulatory agency it created have both upon occasion displayed a penchant for thinking that the disease to which futures markets are prone is "too much speculation." Read the Congressional hearings on the coffee market, or on the onion and potato markets, or even some of the Com modity Exchange Authority's studies of the latter, and you will discover this tendency to find the fault of "too much speculation." Actually the lame and the halt among futures markets are characteristically afflicted with "too little spec ulation." A few years ago one of the young Modesto ash trees in my yard appeared to be dying. The leaves turned brown and brittle in midsummer, then dropped off. The first diagnosis that I read described these symptoms exactly and said that many cases were being reported, owing to the unusually hot winds which were searing the leaves and drying the trees out faster than ground water could rise and restore the neces sary moisture. The prescription was heavy and prolonged watering, which I immediately undertook, only to reverse

IMPORTANCE AND EFFECTIVENESS OF HEDGING the treatment abruptly when I read a second article. This second article described the particular wilt which had the aforementioned symptoms, and noted that the fungus which caused the wilt was favored by moisture around the roots. The prescription was of course to aerate and dry out the roots, thereby discouraging the fungus. This treatment was soon effective, whereas many who followed the opposite advice lost their trees. The authoritative article reminded the read er that this tree was native to California's hot and windy Cen tral Valley and was highly drought resistant — appealing only to his common sense to suggest that whatever hot and dry winds were blowing in the San Francisco Bay area could be easily withstood by the Modesto ash. The Modesto ash can quickly suffer and soon die from too much watering, but it is scarcely likely to suffer in the pre vailing climate from lack of watering. A futures market can quickly suffer and soon die from lack of speculation, but it is scarcely likely in the prevailing climate to receive too much speculation. I think that the correct view has come to prevail regarding the Modesto ash tree despite the fact that a brown and withered leaf superficially suggests insufficient water ing. The human mind can, after all, perceive certain subtle ties. But the official view of futures trading is still one, figur atively speaking, of watering a sick Modesto ash tree, the subtlety being as yet officially unperceived.

In summary(J:utures trading depends upon hedging. Any outside factor which reduces the need for hedging, such as government stockpiling, impairs futures markets by reduc ing the need for them. As the need is reduced, so the use is reduced, and reduction in use impairs usefulness. This is the acute and immediate and unsubtle threat to futures trad ing. [81] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

The chronic threat to futures trading is lack of under standing of the more subtle point that effectiveness for hedg ing depends upon speculation. Without hedging, it is true, there would be no futures trading; and the ,higher the level of hedging the higher the level of business, J on futures mar kets. But the higher the level of business oh futures markets the larger will be the proportion which is speculation, be cause the larger this proportion the more effective will be the market for hedging^) /^The future of futures trading according to this analysis, depends upon two conditions. The first is the method by which farmers' incomes are supported. Some rationalization in this method, which would permit a larger scope for prices made on efficient free exchanges, and in particular would reduce government stockpiles, would stimulate futures trad ing.! A number of techniques have been proposed which go irimis direction; but I will not venture to guess on the pros pect for any such change. (The second is the level of under standing of the function of futures markets — of the opportun ities for hedging and the need for speculation?) If and when a turning point does come in the farm program, it would be bitter irony to have it culminate in renewed attacks upon futures markets. Evidence of their dependence upon hedg ing, and of the effectiveness of the more speculative markets for hedging, needs to be stockpiled against this emergency.

Importance and Effectiveness of Hedging James P. Reichmann Roger, I agree that the effectiveness of hedging depends on its cost. Hedging transfers the business risk which re sults from change in price to others. As in the other risks that the businessman passes on to professional risk bearers in the form of insurance, cost as well as the magnitude of any one possible loss are the motivating causes. I agree in part with your conclusion that relatively high levels of speculation maintain a market liquidity which low ers the cost of hedging and makes it effective. I think its effectiveness also depends on a relationship which I will dis cuss later. As to the statistical method you have used in support of your conclusions, I agree to the validity of comparing the Minneapolis and Chicago wheat futures because both are to some degree influenced by the same causes, and the pre miums or discounts at which the successive replacements of futures are made are probably sufficiently comparable. The first Chicago March wheat purchase was sold on March 1, 1950 at 2203^ and replaced simultaneously with a purchase of May wheat at 213^£ or at a discount of 7$. This contract was replaced on May 1, 1950 with a purchase of the July future at 218%, a discount of 13%^. The next eight re placements were made with purchases at premiums over the future disposed of, ranging from i/2^ to 6^. The first purchase was replaced forty times, thirty at a premium for the new contract, and ten times at a discount. The first purchase and last sale were made at practically the same price. The discounts and premiums at which the successive purchases were made are in my opinion attributable to the relative abundance or scarcity of the free stocks of wheat on each date of replacement, the former a cause of

[83] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR premiums which in part reflect carrying charges, the latter the cause of discounts for the succeeding contract. These premiums and discounts also reflect the liquidity of the mar ket and thereby offer a measure for comparing the two mar kets. Now inasmuch as the successive purchases of the other com modities in table II were made at premiums and dis counts, and to the extent that these premiums and dis counts reflect abundance or scarcity of the supply of each distinct commodity, I do not see how they can be compared and how those comparisons can be used in support of your conclusion. The other factor on which I think effective hedging de pends is the relationship between the cash market and the futures market. If cash and futures move together hedges can be placed and lifted with a minimum of cost. If one market moves independently of the other the effectiveness of hedg ing is threatened. It is obvious that a hedge placed in Chicago on wheat stored in Buffalo would not be effective if Chicago futures ad vanced twenty cents while the cash price at Buffalo remained unchanged. To move the wheat to Chicago and make de livery on the futures contract would involve prohibitive freight charges, and to lift the hedge and sell the wheat at Buffalo would involve a twenty cent per bushel loss. The Chicago Board of Trade does three things which help to maintain this relationship between the cash and futures markets. It encourages the building of storage facilities here which in turn insure large stocks of deliverable grain, which in themselves tend to prevent a distortion in the relationship of cash and futures. There are 68,625,000 bushels of public elevator space here, 65,135,000 of which is regular for de livery on futures contracts. The Exchange supervises the ac-

IMPORTANCE AND EFFECTIVENESS OF HEDGING tivities of traders through its Business Conduct Committee, which is ever on the watch for attempts at manipulation. And it makes every effort to have as a medium for futures trading a contract which reflects the grades of grain grown by farmers and marketed here, as well as one that will appeal to the pur chasers of these contracts, namely the processors, exporters and speculators. This is not the simple or static problem that many people think. Improvement in grades and the yearly changes in grow ing conditions make it subject to constant reappraisal. In 1952, 782 cars of corn out of 45,573 inspected at Chicago graded #1 Yellow, in 1958, 10,358 out of 49,929 graded #1 Yellow. The wheat contract has been changed four times since 1952; corn and oats both twice since 1957. All of these things have been done in the attempt to maintain the delicate relationship between hedging and speculation, the importance of which you have demonstrated so well. I would like to extend the scope of this discussion to some of the factors that contribute to the liquidity of the Chicago Board of Trade commodities which you have studied. There are 1,422 members of the Board who maintain 299 Principal Offices, 1022 Branch offices and employ several thousand solicitors. Their activities consist largely in their own hedg ing and speculative accounts in the United States as well as many foreign countries. As a result of much of this activity huge sums of risk capital are made available to assume the hedges that are placed in the market. Eight hundred of the members are located in Chicago. Many of these members are floor traders and are always present on the Exchange and are willing to trade at all times, thus giving an immediate liquidity to the market. The Commodity Exchange Authority no longer imposes [85] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR its former limits of trading, other than actual hedging, on processors, and allows them to place hedges in the market that anticipate their future needs. This may at times strain the liquidity of the market. Your able demonstration of the dependence of hedging on speculation would point to the conclusion that the Commodity Exchange Authority should also reconsider the trading limits imposed on speculators.

Importance and Effectiveness of Hedging C. Peairs Wilson The author presents his paper in three sections — namely, (1) The Importance of Hedging, (2) The Relationship be tween Hedging and Speculation and (3) Evidence on the Effectiveness of Futures Markets for Hedging. Your review er proposes to offer a few comments on each section although primary interest centers on "a particular piece of new evi dence" on the effectiveness of futures trading for hedging. The section on The Importance of Hedging, starts with an admittedly categorical statement: "Futures trading de pends upon hedging." The author then cites some evidence supposedly to support the categorical statement. He presents some general observations concerning patterns of open in terest for wheat and corn apparently to justify the following statements: "the open interest in futures follows closely the commercial stocks or visible supplies data. This is the strong est single class of evidence of the dependence of futures trad ing upon hedging." Up to this point, then, the reader is led to believe that the strongest evidence of the importance of hedging is that commercial stocks or visible supplies are, either in total or in substantial part, hedged, and that this hedged position accounts for a substantial proportion of the open interest. This argument is destroyed, however, in the very next sentence which says: "Even in markets where large proportions of the commercial stocks are not hedged, the minor fraction that is hedged characteristically dictates the pattern of open interest." This reviewer is unable to deter mine which is the more categorical statement: (1) "Futures trading depends upon hedging", or (2) "Hedging dictates the open interest pattern." Neither statement says much to this reviewer about "The Importance of Hedging" which is the title of the section. If importance is judged in terms of

FUTURES TRADING SEMINAR the quantitative volume of transactions or the proportion of transactions or the proportion of commercial stocks, or the number of, or proportion of, firms making use of futures markets for hedging purposes, such evidence might well have been brought to bear on the point. Bringing in some casual observations about patterns of open interest as evidence of the importance of hedging seems superfluous. In the second section the author takes up the relationship between hedging and speculation. This reviewer will ad mit that perhaps the man on the street does not understand the role of speculation in futures trading and, further, that perhaps some politicians have used speculation as a bad word. However, for a group of economists and businessmen daily engaged in futures trading, there would seem to be little need to justify the role of speculation in the futures markets. The essential point is that for every sale there must be a purchase and vice versa. If there is to be an effective hedging market, there must be sufficient liquidity in the fu tures market to make prompt transactions without undue price concession. Each transaction to place or remove a hedge must be accompanied by an equal and opposite transaction on the part of another party. The other party may be either another hedger or a speculator. It would be a continuing series of coincidences if in every case the other party were another hedger — hence the role of the speculator. The au thor uses some tabular material showing the composition of long and short open positions by classification as hedgers, speculators, spreaders, and small-scale operators. By washing out the spreading positions and assuming that most of the small scale operators are speculators, he arrives at the pre sumption that there is sufficient liquidity for an effective hedging market for wheat, corn, oats, and soybeans. In the

IMPORTANCE AND EFFECTIVENESS OF HEDGING process he raises questions about the effectiveness of cer tain other markets such as bran and coffee. From the presumption of effectiveness for hedging, the author proceeds to the next section on "Evidence on the Ef fectiveness of Futures Markets for Hedging." One criterion of the effectiveness of a market for hedging is the cost of hedging. One dimension of cost is, according to the author, "the expectational bias," which the author considers "the most important dimension of hedging costs." The author then proceeds to determine "whether the profits or losses from the long side in certain future markets differs signifi cantly from zero. In nontechnical terms, an attempt is made to ascertain statistically whether the market is balanced pricewise, or lopsided in favor of the long or short side. A bal anced market, one in which there are no profits or losses in the long run from maintaining a perpetual long position, is clearly an effective hedging market." To this reviewer, it is not at all clear that a "balanced market" is necessarily an effective hedging market. Dr. Gray attempts to clarify this in a later supplement to the original paper. He says that "the cash-price series is car ried in the futures price series through the artifice of making all the paper transactions on the first trading day of the de livery month, i.e., the day on which, in general, the price of a future contract has just become a commodity price." I won der if, for his analysis, he has not taken a special case. Hedg ing transactions are not made and closed out on this kind of schedule. What would an analysis show if the paper transac tions had been made on other days representing actual or hy pothetical hedging transactions? He argues that a comparison of the variability of the basis with the variability of cash prices is a meaningless test "be- [89] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR cause it presupposes not that most hedgers are arbitragers trying to get ahead in the world, which they are, but that they are a queer sort of conservative commercial idiot striv ing always and only to break even." The hedger is a busi- man as much interested in a profit as any other businessman. But a hedger, rigorously defined, expects to make a profit from sources other than erratic fluctuations in either prices in the spot market or in the basis. It is not clear to this re viewer that comparisons of the variability the basis with the variability of cash prices is a meaningless test and if it is, it is not for the reason given by the outline. Admittedly, basis should vary through time as the author states. The question is: does it change so erratically that it makes hedging inef fective — does the hedger assume more risk than if he had not hedged? The author proceeds to test the hypothesis that certain markets over certain time intervals were balanced. He finds that the Chicago wheat, Chicago corn, and Chicago oats mar kets were balanced from roughly 1949 to 1958 and that the Chicago soybean market was from 1955 to 1959. On the other hand, he finds that the New York coffee market (1950-58), the Minneapolis wheat market (1949-59), the Kansas City bran market (1947-52 and 1955-56), and the Chicago soybean market (1948-53) were not balanced. He draws the conclu sion that "markets with relatively high levels of speculation are most effective for hedging and those with low levels of speculation are least effect for hedging." He presents no quan titative data with respect to the level of speculation in any of the markets which were found to be unbalanced. It is interesting to note differences in the author's treatment of the Chicago soybean market and the Kansas City bran mar ket. Of the Chicago soybean market he says, "The soybean market was a relatively ineffective hedging medium during

IMPORTANCE AND EFFECTIVENESS OF HEDGING its rapid growth phase. Fortunately hedgers were willing to support it through this phase and they have been reward ed with an effective hedging medium as the market reached maturity." Of the Kansas City bran market he says, "While the immediate cause of the death of this market may be writ ten in the coroner's report as the miller's departure the under lying cause was the ungeneral state of health of a market which lacks speculation." Apparently if the millers had been willing to support the bran market through the growth phase, they, too, would have been rewarded. Would no other speci fication need to be met in order to have a successful bran market?

The author states that up to this time he has found "no surprises nor setbacks for the hypothesis that, to be effective for hedging a futures market needs much speculation." It would indeed be a surprise to find a market that was effective for hedging that did not have speculation. In his summary, the author states — (a) futures trading depends upon hedging (b) effectiveness of hedging depends upon speculation (c) the higher the level of hedging, the higher the level of business on futures markets. (d) the higher the level of business on futures markets, the larger will be the proportion which is speculation, because the larger this proportion, the more effective will be the market for hedging." Point (d) is clearly fallacious as stated. Given an effective hedging market, why cannot the volume of hedging transac tions and speculative transactions increase proportionately? Furthermore if the proportion which is speculation does in crease, it is not "because the larger this proportion, the more effective will be the market for hedging." The result may [91] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR be a more effective market for hedging. Finally, the author states that evidence that futures mar kets depend on hedging and effectiveness as a hedging market depends on speculation needs to be stockpiled against the possibility that, there may be renewed attacks upon futures markets. Lets hope that when evaluations are made they will embody the best possible evidence, based upon careful de tailed research and an educational program which will put the real facts before the public and not emotions, untested beliefs, etc. This Seminar seems to me to be an excellent vehicle for accomplishing this purpose.

Importance and Effectiveness of Hedging Richard Phillips Dr. Gray develops his paper under three major headings — (1) the importance of hedging, (2) the relationship between hedging and speculation, and (3) evidence on the effective ness of futures markets for hedging. Because of the convic tion that his major contributions lie in the third section, most of this discussion will be directed to that part of his paper. But before coming to this, brief comments will be addressed to the two preceding sections. Comments on "The Importance of Hedging" Although he fails to document his comments except for his reference to Holbrook Working's discussion of a singular episode in wheat futures trading on the Kansas City market, Gray argues soundly and convincingly that statistics for com modity after commodity show the close relationship between the marketing pattern of the cash crop (and therefore the hedging needs) and both the pattern and the volume of fu tures trading. This is an orthodox argument with which most authorities are in full agreement. Without attempting to en ter into the Bakken vs. Gray argument on this point, I simply raise the question here as to whether Gray wouldn't have done well to give his readers at least a sample of "the evidence (which) indicates overwhelmingly that futures trading de pends upon hedging." Comments on "The Relationship between Hedging & Speculation" In this section, Dr. Gray spends most of his time in discus sion around his table showing the percentage composition of the open interest for the combined futures markets for four major grains over the period 1948-1958. In his discus sion he points out several possible reasons explaining some of the dissimilarities among the grains in the figures included [93] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR in his table. This is very interesting, but one cannot help but question its relevance to the relationship between hedg ing and speculation or for demonstrating that "hedging de pends upon speculation." Gray comments little if at all here on the sound arguments that are usually made for speculation in futures markets, such as for depth and liquidity in the market, or to prevent ex cessively unstable futures prices. Nor does he give his reader any statistical evidence to support his contention that as be tween futures markets for different commodities the volume of hedging is positively correlated with the percentage of total trading represented by speculative transactions. So, while I am in full agreement with Dr. Gray's conclusion that speculation is needed in a futures market which is ef fective for hedging purposes, I don't believe his discussion in this section demonstrates this to be the case. Instead, he relies on the analysis in his third section to demonstrate this rela tionship. Comments on "Evidence on the Effectiveness of Futures Markets for Hedging" Dr. Gray deserves the appreciation of all of us for this sec tion of his paper, because it represents a pioneering statistical attempt to appraise various futures markets in terms of their effectiveness for hedging purposes. Whether or not we fully agree as to the significance of Gray's test of an "effective" fu tures market as reported to us in this section of his paper, we cannot overlook the scholarly approach he has made and the food for thought he has given us. First let us briefly review Gray's procedure for testing the "effectiveness" of each futures market examined. A several- year series of beginning and ending futures prices are com pared, and the t-test is used to determine whether or not on the average over the entire period the difference between

IMPORTANCE AND EFFECTIVENESS OF HEDGING these starting and ending prices is statistically different from zero. The beginning price used is the price of the futures contract on the first trading day of the delivery month of the preceding future. The closing price used is the price of the futures contract on the first trading day of its own delivery month. The data used are the actual reported closing prices on the days involved for the markets studied. No adjustments were made except in the case of soybeans, where an additional comparison was included. This was the comparison between the last ending futures price and the first beginning futures price for the entire period studied. As is true of any penetrating economic analysis, Gray's analysis of necessity is based on certain assumptions regard ing the important and significant relationships in the prob lem in order to abstract them from the complex and confused relationships of reality. As I see it, the key assumptions to Gray's analysis and conclusions are three in number: 1. An effective hedging market is a futures market in which profits (or losses) from a continuous long position over time are not significantly different from zero. 2. The effects of a perpetual long position can be measured effectively by comparing a series of beginning and end ing futures prices over a several year period, the begin ning price being the price of the future on the first trading day of the closing month of the previous future and the closing price being the price of the future on the first trading day of its closing month. 3. The net profits or losses from such a position over time can be tested effectively by applying the t-test to the mean or average result over the period. As Dr. Gray has indicated, I have had the benefit of cor respondence with him concerning his further justification for the first two of these assumptions that did not appear in [95] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR the first draft of his paper. If I may again take the time to summarize, Gray justifies the first and key assumption for purposes of his analysis on the following grounds: 1. His belief that hedging costs are the most important indicator of market effectiveness, and that the "expectational bias" (anticipated profits or losses from a per petual long position) is the most important dimension of hedging costs. 2. This measure is rigorous, and classifies as ineffective futures markets which have had a relatively low level of speculation to hedging, and a relatively low level of hedging compared to the potential. 3. A study of the change in basis as a hedging cost would be sterile, because (a) all exchange markets would show less variability in the basis than in spot prices, (b) mar kets with a high variability in cash prices would score as more effective than they actually are, and (c) such a study would falsely assume that most hedging is mo tivated by less variability in the basis than in the spot prices. Now I come to my reaction to each of Gray's three points justifying his first and key assumption. I accept the proposi tion that hedging costs are the most important indicator of the effectiveness of a market for hedging purposes. But while I have no statistical or analytical evidence to the contrary, I have an uneasy feeling about the proposition that Gray's "expectational bias" is the most important dimension of hedging costs. Since a hedged position is by definition two simultaneous transactions, only one of which is in the hedg ing future, it seems to me the hedger always must have major concern about the cost of his expectation of the basis going against him. For a total test of the effectiveness of a futures

IMPORTANCE AND EFFECTIVENESS OF HEDGING market for hedging, it would seem only logical that one would need to consider at least some of the factors in the relation ship between cash and futures prices, the needs of the hedg ers, the nature of their operations, their geographic position, their ability to deliver on the futures and related matters as well as the average result of a perpetual long speculative position in the market. On Gray's second justification of this first assumption — that it classifies as ineffective markets which have been inef fective and as effective markets which have been effective — there is little that can be said. The analytical researcher is always happy when his results square with his intuition or empirical observation of what the results should be. It is a justification in terms of result, rather than logic. There are two kinds of dangers here, though. Intuition and observa tion are not perfect — if they were, the whole analytical pro cedure would be completely unnecessary. And secondly, non sense correlation is a possibility. For example, one would not necessarily accept an increase in futures prices on the first trading day in January as a valid test of market effective ness even though it correlated perfectly with one's "outside" knowledge of which markets were effective. So while justifi cation of an analytical procedure in terms of its predictive result is sound, without additional justification in terms of logic there is not sufficient justification. Gray's third justification for his first assumption essential ly is that for several reasons variability in the basis can be ignored in testing the effectiveness of a futures market for hedging. I agree that neither the degree of stability in the basis per se, nor a comparison of the variability in the basis with that in spot prices is an adequate test of a market's ef fectiveness for hedging purposes. But if the basis were both unstable and unpredictable in a probability sense, I am sure

[97] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR that potential hedgers would find it difficult to hedge effective ly, even in a market which turns out to be effective by Gray's test. This is not a problem in Gray's analysis or his conclusions if the futures prices do in fact exhibit a predictable relationship to the cash prices in the markets to which he has applied his tests, and I certainly expect this is the case. But a predictable relationship between the two does not follow necessarily from the analysis itself.21 So perhaps the single test used may be a necessary test of hedging effectiveness, but in itself not always a sufficient or complete test of this effectiveness. The second assumption implicit in the analysis is that the net gain or loss from a perpetual long position can be closely approximated by comparing the price of the futures on a single beginning date with that on a single ending date. Granted that Gray probably has selected the most representa tive single dates for entering and closing out the long posi tion in each future, (and at least to me he has justified this selection very well) the use of the prices on two single dates of necessity overlooks interesting and perhaps revealing price movements between and beyond the dates used. A similar analysis in greater detail in this respect might well provide more insight into and a more careful appraisal of the futures markets studied. The third implicit assumption in the analysis made is that the profits or losses from a hypothetical long position between the two dates in each future can be judged solely by the fac tors taken into account by the t-test as it has been applied. Of course, there may be other characteristics of the distribu tion of these profits or losses over time (range, order, bunch ing, median, etc.) that would be helpful in a more detailed

xAs Gray has effectively pointed out in his final paper, since the closing futures price used in each case is on the first day of its delivery month and therefore is approaching the cash price, the analysis does contain a built-in factor which considers this relationship to some extent. [98] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING appraisal of the markets studied. So to summarize my comments on this third and major sec tion of the paper, I believe that Dr. Gray has made an impor tant contribution to the analysis of futures markets and ef fectiveness for hedging. But I view the work as pioneering rather than exhaustive and final in nature. And perhaps we should interpret the classification of the different futures markets as effective or ineffective by the tests made as some what tentative until more detailed analyses can be made. In any case, we can certainly hope that Dr. Gray will have the time, the interest and the encouragement to extend his research and analyze the different futures markets in more detail.

Importance and Effectiveness of Hedging Discussion EN IX: We have adequate time for discussion, and we cer tainly have different points of view, not only in Dr. Gray's paper, but in this morning's paper as well. And we promised our principal speaker that we would give him an opportunity to rebut with any remarks that he would care to make. I noticed that Dr. Gray has been mak ing a considerable number of notes and will call on him at this time to answer any questions that were raised regarding his paper. [99] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

GRAY: Well, thank you. I am in the opposite position from that that Henry Bakken found himself in this morning. As I put it — he hasn't bought this yet — he has an excellent paper with two bad paragraphs; I, obviously, have a bad paper and I wonder if we could find two good paragraphs. (Laughter) I probably didn't understand some of these comments as well as I might have. That turnabout is fair play, because some of these people said they didn't understand what I have said as well as they might have. But I have jotted down — and I don't take shorthand so I probably didn't jot down enough to be sure what I wanted to say here on each of the discussants points — just partial rebuttals that I would try to make. We start with Jim, who questions the validity of a com parison between the Chicago wheat market and others, such as the coffee market, and goes on to make the point with which I am in full agreement that when you are buying these things at a discount or premium as a relationship, that people un derstand — REICHMANN: Plus the liquidity. In other words, maybe they had supply conditions that made them appear to be less liquid than, say, the Board of Trade, under that statis tical method. Whereas, in fact, it wasn't the lack of liquidity, it was just a different supply situation. And, really, I agree with the conclusions and I agree with your whole paper. The only thing I would like to have a little light on is can you separate those two elements? GRAY: Well, to get to this comparison — I would defend it. And I would say this, so that we are all clear on one thing: I am sure Jim and I are in agreement on one thing, that I have no desire to make these other markets look bad in con trast to the Chicago Board of Trade. There is nothing I would [100] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING like better than to see these markets be adequate. I think there are inadequate hedging markets and I think that is the reason the bran market died; it was an inadequate hedging market. But I would like to make this point in the following way here on the blackboard, if I can. Now, in this program we talked about buying say a May future on March 1st. And let's say at a 10 cent discount from spot values. Now, it means two different things on these two different markets; and what I want to stress is that when you look at the 10 cent discount on the Chicago wheat market, you can not interpret that as a forecast that prices will rise. It is a fair market. When Mr. Carey purchases at a 10 cent dis count on the spot, the mere existence of a 10 cent discount on the spot doesn't guarantee him that he is going to make some profits. In the coffee market it does; and that is the difference; and that is why I think the comparison is good. So stretch this out for about ten years. We had about 40 or 50 trades and here is the picture that you get. (Drawing chart on blackboard) Here is the wheat; this will be erratic. This will average zero over a period of time. We bought at a discount here; we bought at a premium here. And, in general, that is a seasonal phenomenon; and it is in the tag end of the crop season that you tend to find your discount. It is during the harvest season that you tend to find your premiums, when you don't have Government activity so prevalent in the pic ture. And my test really is a test of whether in the long run those discounts and premiums average zero. That is another way of putting it. But in the coffee market, for illustration, when you buy something at a 10 cent discount you are not entitled to say that that 10 cent discount is an inverse carrying charge. [101] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

The hedger is going against the market; that's all. My point is there is an important difference between the coffee mar ket, which I would call a discount market — let me draw my other picture. That is wheat, you see. We are approaching this price series above and below. In the coffee market, which many of you here already know, if you draw the same picture, it has been approaching zero from below regularly. (At this point Dr. Gray sketched a diagram on the black board, showing the contrast between a discount market such as the coffee futures market, and a market which reflects car rying charges and inverse carrying charges without a general bias, such as the Chicago wheat futures market. If adjust ment is made for changes in "spot" prices, so that these ap pear constant over a period of years, then futures prices ap proach these from below in the coffee market; but from both above and below in the Chicago wheat market. The average basis does not differ significantly from zero in the wheat example, but is significantly greater than zero in the coffee example. The chart which Dr. Gray had in mind, and sketched only partially and crudely on the blackboard is shown in Figure 2 on page 103.) These things have different length. In other words, there is some inverse carrying charge in here, but less always the bias. So what you have got to do with a coffee market to equate it with the wheat market to discern which is inverse carrying charge and which is bias is to measure the bias first of say 2 cents. Redraw this down here (pointing to the horizontal "main bone of the chart) so that then the origins of these futures prices will start above and below that line, having eliminated the bias. And the hedger who has to go into that market, as he does for instance in the coffee market, is in a terrible bind. [102] ©1960 Mimir Publishers, Inc. IMPORTANCE AND EFFECTIVENESS OF HEDGING

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The short hedger who is an importer is in an awful bind. His banker makes him hedge because his bank blindly be lieves in hedging. The importer has got to find a way to keep from losing 2 cents every time he sells a hedge; because he is an importer on narrow margins and you can't lose 10 cents a pound on coffee per year and stay in business. So he goes to the green coffee market which is a forward spot market not a futures market. But roaster hedgers have done well in the coffee market. They jump over to the long side. If you can't fight them, join them then. That is a lot different than in wheat. And, now, you are carrying your inventory in the futures market. Here he can jump from a short side to routinely absorbing a pro tective hedge. So I think the comparison is not only valid, but important. REICHMANN: I see. I will say that I had reconstructed this whole thing on wheat at a little expense of time. I didn't have a chance to do it with the other commodities. I just thought that possibly there was a lack of comparable sit uation. GRAY: Coffee you bought at discount; not every one in wheat. My only other comment on Jim's paper — and no pun is intended — is I don't see why hedgers insist on selling themselves short. But it does seem to me that Jim's reaction here is to sell the hedger a little too short, and not give him his full credit. I'm very skeptical of the parallel that you draw between the specialist on the Stock Exchange and the floor trader on the Board of Trade. I would far rather trust the latter's motivation than the fear of suasion from above. I think it's dangerous to compare the two because I think you will sell this market short if you compare it to the stock market, which isn't as good a market. [104] ©1960 Mimir Publishers, Inc. IMPORTANCE AND EFFECTIVENESS OF HEDGING

REICHMANN: I just have no other evidence to offer. I thought at least it should be known that these people just aren't wearing white clothes or — GRAY: I'm agreeing with you — in a very belligerent way — because you gave me a bad time. On Dr. Wilson's discussion, there are really too many points and I couldn't keep up with them. I've tried to select a point or two that I think maybe he would say are most important; but he would probably say that he would advise something else more than these points. A point on which I disagree with him, he says the essential point — and this can't be an exact quotation, Peairs — is that for every sale there is a purchase. That is, after all, we kind of knew that it took speculation to make a good hedging market because for every sale there is a purchase. And in rebuttal to this, I say this was true on the bran mar ket the last minute before it died. And this is true in the coffee market today. And this is true in all the weak sisters, that for every sale there is a purchase. It is true and it is kind of meaningless, I think; and I don't think it is an es sential point. The essential point to me in this comparison is that the bran market is dead because it wasn't an effective hedging market. Yet, you can say all day that for every sale in that market there was a purchase. On, "The hedger is dealing with," what I believe you call, "a variable basis." I have forgotten just the term that you used. But you intimated, I guess, that the hedger has a right to expect some kind of stability in the basis and not have to deal with the variable basis. I'm willing to rest my views of the hedgers operation very strongly on the talk given at the Symposium last year by Mr. Ben Raskin. I think it is the hedger's business to forecast the basis. [105] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

Now, obviously the hedger knows that the basis is going to go to zero. So if it is plus or minus 10 — I don't mean forecasting simply that it is going to go to zero. This is his stock in trade and he has got to know this; but in making his transaction he is trying to guess whether it is going to get big ger before smaller or smaller before it gets bigger. And I think that is the essence of the hedger's operation. What did I say about you, Dick? Well, just extending what I said about Peairs' discussion. The essence of what I'm trying to say is the contrast between these two markets is that the hedger has got to have a fair opportunity to fore cast the basis or it isn't a fair market for him. And what I'm saying is, sure the hedger has to use a market sometimes that isn't a good market for him to operate in. He is not getting a fair shake in such a market and he wouldn't use it forever. He'll go seeking other ways of protecting himself than these futures markets just as hedgers did in the bran market, just as they are tending to do in the coffee market, and just as they are heading in Minneapolis in the wheat market. And the contrast to me means that in this market the hedger has got the fair opportunity to forecast the basis; in this market he hasn't, the dice are loaded every time he uses them. Okay, now you can fire away. WILSON: On the first point you made on my paper, that for every sale there must be a purchase and vice versa, I think we are together on this. The point is if there isn't someone to take the opposite position, the speculator — GRAY: There has been somebody to take the opposite posi tion. And he is going to take the opposite position when you come in and go out; and he is going to nick you both ways. And that isn't a fair market for you to use. You get nicked coming and you get nicked going; and pretty soon you don't come back. But, I guess we are in agreement.

IMPORTANCE AND EFFECTIVENESS OF HEDGING

PHILLIPS: Well, let us explore using the charts here. Would you go ahead and explain, Roger, how your test effectively demonstrates that those markets that check out on it as being suitable for hedging, do in fact, or are in fact those in which the hedger can predict change in basis. It would appear just on the surface — GRAY: I don't say that he can. I'm not talking about a hedg er's ability to predict the basis; I'm talking about his oppor tunity. And I'm saying that he gets the opportunity in the long run if the statistical value of the basis is zero. In this one, his long run value is 2 cents against him and he is in a loaded market. The hedger knows, and that is why he finds ways around the coffee market. PHILLIPS: Are you also saying that this is caused by, as Jim was I think arguing, supply and demand factors and that a polished hedger can observe and predict with some degree of accuracy where these others are caused by or don't have such a relationship to the factors? GRAY: They have that in it, too, you see. In other words, I think the coffee market has done a reasonably good job in forecasting prices in coffee; except it has got a 2 cent bias in it. I think they are playing for keeps; they are trying to guess coffee prices. PHILLIPS: And you think your test takes both of these into account. GRAY: I guess I'd have to say I don't know. I don't think I can sort out in this picture of the coffee market what por tion of a particular slant bar here is, say, inverse carrying charge and what portion is bias or discount. All I'm saying is that in general I have measured this bias as discount. In a particular case, I just don't think you could separate them. I did want to talk on this other point, by the way. I don't [107] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR know the status of it now, and I don't mean to be opening up any particular hornets' nest, but there is an allegation made on this market recently that it is loaded against a par ticular class of trade. What I'm getting at is you have ways of measuring whether a market is balanced over a period of time. Now, if a person making this allegation means it was loaded the last two contracts, I don't think you could point out statistically, objectively, whether it was or not. But the thing that I should have stressed more in my paper than I did is just the point made by Jim; that what you have to do is always revise your contracts and keep abreast of the fact that they do get out of balance. And some markets are less active hedging media than the Chicago Board of Trade has been. Or maybe there is some body who likes the fact that there is bias in the market or what have you. But generally, you can certainly say in the Chicago Board of Trade that they have kept the thing honest. Maybe the last two or three times it wasn't for somebody; I don't know. BUELL: There is just one question I would like to ask you: Is there a difference in comparing that coffee market to the wheat market from the standpoint that we are importers of coffee, when we are exporters of grain; and coffee is sold in the pounds and wheat sold in bushels? GRAY: The last part of your question I don't get. On the first part, I think I get the point. The fact that we are im porters of coffee versus being exporters of wheat would be important if Liverpool were the chief wheat market instead of Chicago. Chicago is an honest market. Liverpool has been an important cotton futures market. And you have the same situation in Liverpool cotton futures market as you have in the New York coffee futures market; namely, that the trade over there doesn't believe that the United States is a

IMPORTANCE AND EFFECTIVENESS OF HEDGING strong seller of cotton just as our trade doesn't believe that Brazil is a strong seller of coffee. But, in the long run, the trade is right because Brazil's price structure weakens. Similarly, the cotton traders on the short side in the Liverpool cotton market took a beating because they didn't believe in the United States in selling its cotton. But the United States finally got around to the point where it weakened as a seller of cotton. This is written up, by the way, in an article in Three Banks Review, sometime in 1958; it's a quarterly.22 And it shows the Liverpool cotton market situation beautifully; and it is an exact counterpart of the coffee market, excepting that the bias was not nearly so great. Because, after all, they know that we've got a pretty deep treasury here and we know that Brazil is pretty weak. Nevertheless, we did weaken in our cotton price supports and Brazil did weaken in coffee supports. BUELL: My second point, if I didn't explain it properly: don't we sell grain in huge quantities and coffee in small quantities? It makes quite a difference in the market where you can keep — GRAY: Not at the level of the use of the market. The im porter of coffee is importing more valuable boat loads of stuff than the exporter of wheat is exporting, by a good deal. And they import it by the boat load. They price by the pound as a matter of convenience. Another way of looking at it, it must be true isn't it that the coffee contract has just about the same value as the wheat contract? A Brazilian coffee contract runs about the same value as a wheat contract here, figuring wheat at $2.00 and coffee at 33 cents a pound to be exact. BUELL: Would you believe that coffee is more controlled

22 B.S. Yamey, "Cotton Futures Trading in Liverpool," Three Banks Review., March 1959, page 21-38. [109] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR than wheat? We only use so much every year. That amount is brought into this country; it's easier to control. GOLD: I don't think so at all because they have been very good in bringing up consumption in the United States through campaigns which you haven't had on wheat as much. And I would say that probably the total value of the coffee imported is a great deal more than the exports of your wheat. GRAY: That is true. As a matter of fact, we can make that comparison directly. The total value of our coffee imports is approximately equivalent to a total consumption of wheat in the United States. That is at $2.00 for wheat and at 33 cents for coffee. So it is big. REICHMANN: Actually, the coffee market has been much more elastic than our wheat market, consumption per capita. FLOOR: You've been going down and the other has been going up. SCHRUBEN: What alternative measures do you propose to measure the futures for hedging? You have selected one. What other alternative courses of action? You must have considered several before hitting on this one. If you did, they have to confirm this. GRAY: I'm embarrassed because it is a good question and I'm sure the answer is, I must have. But I don't know what I considered. I would like to talk to you later about what I can remember. Off hand, I don't know. SCHRUBEN: Two different approaches bearing on the same point, demonstrating the same conclusion perhaps would be useful. I was just curious to know. GRAY: I'm sure it would. I'm sure there are measures for hedging other than this, but I don't know what they are. ABSHIER: Roger, without having a chance to study your paper, maybe I didn't have a chance to understand your

IMPORTANCE AND EFFECTIVENESS OF HEDGING hypothesis. It seems to me that you set up as a hypothesis a good hedging market, one that would approach zero. Then you allow for statistical error, for chance. If you had a hedging market where your net result would be zero, are you not discounting or failing to recognize the cost of supplying this risk capital and the cost of brokerage? In other words, isn't there a cost in there that you have to take into account? If you had a perfect zero hedge market, what would be the source of your risk capital on the part of the speculator in terms of return of your money? It seems to me that you pay a very high return for risk capital on the stock exchange, for example; higher than you do for non-risk capital. Shouldn't you make some allowance for that? GRAY: I'm glad you brought out the point. That is in a sense, I think, a flaw; though the contrast really is very great. I mean, the contrast here is so great as to swamp the effects of commission charges and interest on margin, for example. Nevertheless, I'm glad you brought out the point that these computations were made without consideration of com mission charge or interest charges on margin. What we are doing here is to measure the effectiveness of these markets for hedging. If you say you are trying to find out how much money you are making in these markets by a routine trade, then people perk up their ears. I did that one time for coffee, and I did take into account the brokerage commissions. I can't give you the results right now excepting to say that after adjustment for brokerage commissions you would still find that the markets that I have said are statistically biased are biased; and those that are balanced are balanced. ABSHIER: Maybe that cuts the cost of risk capital on the part of the speculator, what you call bias. [Ill] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

PHILLIPS: What you had to pay, you mean, to induce the speculator to take — GRAY: No. Well, okay, if you want to say that. The trouble with the coffee market — I would put it this way — is that there's inadequate buying in that market and that makes a hedge cost too much money. Or, would you simply put it this way, that there is not enough risk capital, or the cost of bringing risk capital to this market is too great. In a practical sense, my feeling, George, is that you get closer to the crux of the futures market if you state it the other way; but there is nothing incorrect, I think, in stating it that way. It costs too much to attract risk capital to the coffee market; I believe it does. BROOKS: In this question that Schruben was getting at, isn't there another alternative, and couldn't it be measured? The alternative of holding cash wheat rather than hedging it in an unacceptable or poor market. Is this an alternative; could it be measured as an alternative? GRAY: Yes. And in a sense you see, you have gone into a different line of business, and it is a very real alternative. You are no longer in a business then of forecasting the basis. But it is the kind of thing that goes on in all markets where they don't have access to a good futures market. BROOKS: Well, suppose a trader were to ask this question, say in the Pacific Northwest: Should we hold cash wheat or should we use the Chicago market? GRAY: He has the same basis forecasting problem as the guy right here, plus he has a big separation in distance which gives him a big geographical basis he has to worry about as well. And judging by the reaction to a Pacific Coast con tract that was inaugurated here, he would rather not fool around trying to do both. He would rather do what is sug gested as the alternative to it. This is what he is doing. [112] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING

I don't mean to imply by this, however, that I don't think it is worthwhile or that I think it is not worthwhile to at tempt to educate people to the possibilities of using futures markets. I think that is something which is grossly under done, and more of it ought to be done. Lots of people on the West Coast for example tend to take it for granted that, well, we are out here and the markets are back there, and we deal with coffee or potatoes here and therefore those markets don't mean anything to us. And in some instances those markets would mean some thing to them if they learned how to use them. And there are those that use them as hedgers. GOLDSCHMIDT: There is some discussion between the wheat market and the coffee market. I'm trying to offer something in support of your analysis which you might look at from another point of view. I think all of us realize that some commodities are more suit able to futures trading than others, and some of the char acteristics of these commodities make it so. In other words, we know that wheat is more suitable for futures trading than, as someone mentioned, maybe trading in refrigerators. And one of the reasons is that there is a broad interest in the commodity by many buyers and sellers. Let's list coffee. I would say that there is not as broad an interest in the United States as there is in wheat. It brings out Mr. Buell's point of view. You have only a few importers with this interest on the supply side, where there would be many sellers in the wheat market. You must have many buy ers and many sellers for an effective futures market. The second one would be seasonal production. It is im portant to the liquid futures market. Seasonal production, when you import a commodity, is to a certain extent elimi-

[113] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR nated because it depends on several other conditions: money, shipping, and what have you. Another item may be standardization. The item must be standardized. I don't know what the standardization prob lems are in coffee, but I do know they are well established and well-known for commodities sold here. Another one may be the storability. I don't know what the storability of the coffee is as it is brought in or what some of the complications are; but I do know that we know how to handle wheat and store it. Now, one measure of whether a market is a good one or not is: To what degree does the commodity suit some of those char acteristics. And I think some inquiry could be made along that line which may actually support your analysis. But I think this may be another approach to a liquidity of the market. And as far as a hedger is concerned, he needs a liquid market. GRAY: I quite agree and I would just like to expand a little bit on that. I have been worried about whether the hedger gets a fair shake. And, of course, to have a good market the speculator has to have a fair shake, too. And you lack the interest in coffee because the potential speculator doesn't really feel that he can trust the informa tion he can get on crop conditions in Brazil. Hence, it isn't as attractive to him; and hence he feels he has got to have a little extra reward if he is going to take chances in that market. But that, by no means accounts for a full sweep of bias that has existed in the coffee market since the Brazilian sup port scheme came in and since the trade up here had to mis trust that support scheme. The coffee market used to be reasonably balanced and reasonably used. I'm willing to grant that it is unlikely to [114] ©1960 Mimir Publishers, Inc.

IMPORTANCE AND EFFECTIVENESS OF HEDGING achieve the same level relative to what would be indicated in the total commercial movement as wheat. I advise you of the cocoa market which is very well used in futures. The open interest in cocoa futures relative to an amount of cocoa compares favorably to soybeans. I would say that probably cocoa is the second best futures market that we have in the United States today. A basic prerequisite is that artificial interferences with the pricing of the commodity be out of there. That is the main thing that a speculator wants, he wants a chance. Secondly — he doesn't want the CCC. or the Brazilian Finance Minister fighting against him. He doesn't consider that a fair contest, and I don't either. But, secondly, I would re-emphasize that he has got to have access to the information. And this does suggest that the commodity we produce, perhaps, in general will have a better futures market than the commodities that we import and cannot know much about. Particularly, if it is a country that doesn't have a very good statistical program; or a coun try that makes up reports as sometimes some of these sup pliers of basic commodities have been accused of doing. GOLD: I just want to point out two things: You might see a significant change in the American coffee market in that they have changed the contracts so that some of the dish coffees are not deliverable. You soon might find your dif ferentials not only on the discount but on your inverse car rying charge. And secondly, I think you are beginning to get some chal lenge as to the criteria of storability necessary to futures mar kets characteristics. And I don't think we want to go into that too much right now; but I think it is important to watch. GRAY: May I elaborate one bit on Mr. Gold's point which I think is excellent. You are finding now that the last, say [115] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR three or four trades in the coffee market have behaved dif ferently from what is implied in my analysis. And I think that this change in the contract specifications is part of it. I still would argue that the main reason for it, however, is that you had a big drop in coffee prices and the trade has gotten to a point where it will believe in prices in the future. SHEPHERD: I misunderstood one of your main points and I would like to have it cleared up. You started out using a measure of the cost of hedging, and then a little later referred to the effectiveness of hedging. My question is whether you have really a measure of the cost or the effectiveness of hedg ing? Because if those on the board were both horizontal and came out exactly to zero, I don't think you would be justified therefore in saying that you had a costless hedge or a defective hedge because that is only part of the cost of hedging. Don't you have to take into account also what hap pened to the cash price in relation to the future, that is, to the basis? And if the horizontal line on every transaction on which you hedged the basis change was such that you made 5 cents a bushel and your measure would show zero; the market would be very effective and cost less than the market for hedging. Whereas if it was the other way, you lost 5 cents a bushel, your market would show zero according to the measure that you used. Therefore, a good market for hedging would be a very poor market for hedging because you would lose 5 cents a bushel each time. So it seems to me that what you need is a measure of the trading change in the basis, rather than the change in the beginning and ending price of the future. GRAY: And let me now put it in this way: the basis goes to zero each time, and again it does in a fair market. So here in [116] ©1960 Mimir Publishers, Inc. IMPORTANCE AND EFFECTIVENESS OF HEDGING each individual case the basis goes to zero. And what in effect I have measured is taking the basis for whatever it is when you are back an average of two and two- fifths months away from the delivery date. Then I have measured this plus 2 and minus 3 and minus 3 and plus 3 and minus 2 and so on across, (pointing to chart on black board) What I have measured is whether that average is zero, which is different from the basis going to zero, which it does. But I have also measured here, you see, implicitly whether or not in the long run the basis averages zero; not at the first day of the delivery month, but two and two-fifths months away from that first day, the best approximation. I might elaborate just a moment. I don't know what you could use for a spot price series for a direct comparison with this; and it wouldn't be a very easy series to get hold of. The best approximation of a spot price series for this purpose is the futures price, the price of the future on the first day of the delivery month. And it is in this sense that I have measured the long run average value of the basis. PAUL: I would like to ask a question: To complete the other side of what you are talking about — the return to the specu lator. Would this be a proper inference in a balanced hedg ing market such as you have conceived? Beyond the cost of the commissions, if the speculator deposits an interest- bearing U.S. Government bond to take care of interest charg es, would his returns approach or be zero? GRAY: If the price of the commodity doesn't change, sure ly. In other words, if a speculator long in this market stays long perpetually, the only thing that ought to make him money is a rise in the price of wheat. In other words, if you start this long series of trades at the same wheat prices that you end this long series of trades, then what you say should hold true. [117] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

PAUL: In other words, the kind of return he is getting is over a long statistical period. The only real incentive he would have to get into the market is to earn the so-called risk premium — is that the term you would use — the return to him above his cost. GRAY: I wouldn't use the term. It has been used, but in the coffee market. If you want to call it that, you can say there has been a risk premium in it. PAUL: Let's not use it then. But there would be a positive return that would reflect the rising price of the commodity relative to other things or units. For instance, the rise of the price in corn from 63 cents to a dollar fifty over a long period of years. He would make that kind of money by staying in. GRAY: If the price does rise, yes. PAUL: But he can't make any money if you postulate a sta ble line over ten years as you have shown. GRAY: (pointing) This line here is the price line. PAUL: In other words, you mean the average person specu lates on the basis of making money which he really can't make. GRAY: Not at all. I'm saying that he has no right to think that all he has to do is sit long forever and he will routinely make money. It was right in the coffee market for ten years, it was right in the Minneapolis wheat market in the postwar period, it hasn't been right in the Chicago wheat market. PAUL: The way I interpret you is — he has to get in and out of the market at the proper time. GRAY: Properly forecast prices. PAUL: But the average speculator didn't make money. GRAY: Or else you can say it in another way, that the turn over is rather high as I expect it is; and you can also divide

IMPORTANCE AND EFFECTIVENESS OF HEDGING the speculators into groups that continuously make money and not have to say that there is another group that loses it. But there is a group that loses money now, and they got out and somebody else loses money. JOST: Has the assumption been that all hedges in these markets would be short hedges? GRAY: That tends to look like the assumption, and it ought to be straightened out. I'm talking about the bias against a short position, really, when I measured the bias in the cof fee market. But note that I did say in the bran market that you had a bias against the short position for four or five years. Then you had a bias against a long position for four or five years; and in the bran market there is no point of talking about hedges short and speculation long, because all the long side was hedge and the short side was hedge, and it is a question of which side was trading more reluctantly. JOST: I think that that assumption about hedges always being short in the market is certainly wrong. The importer is always net short cash coffee when he starts his year, but he knows that he is going to sell his coffee. Therefore, the hedge position should be anticipating sales and be long. GRAY: I wouldn't be as modest as you are. I have lost a couple of pennies in the coffee market so I will say I know a lot about it and I quite agree with you. But I also pointed out earlier that the use of the coffee market to the extent that it was used formerly, was one of maintaining inventory against which they had short positions in the market. It came to be one of carrying inventory in the market with long positions. The importers all the while have been the major short factor; but there really is no assumption here that hedgers are always short. It is one of the facts of life, that hedgers are usually short in most markets. [119] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

PHILLIPS: Certainly this does not in any way invalidate your test, since you measure from zero and a "t" ratio of plus .175 or minus .175, both accepted as unsatisfactory. Just change the sign on those, if you use it the other way. WILSON: Could I ask one statistical question? I have used these "t" ratios in the past, a long while ago. On this bran market you get in the first 23 months a plus 2, and on the second 17 months a minus 1.8. If you throw these together, do these work out to become significant. GRAY: As a matter of fact, I'm sure it did; because the first time I looked at it I expected a bias and it came out not a bias, and I wondered why. WILSON: Did you try separating Chicago wheat? GRAY: I cannot find it in a Chicago wheat market when you find the bias measured this way. It still doesn't test out. SCHRUBEN: Does this mean you select a period so it will prove statistically what you want it to? GRAY: You know it doesn't mean that! This was set up so it would show the same prices in the beginning and the end. But, I'm not above that sort of thing. (LAUGHTER AND APPLAUSE)

Part 3

EFFECTS OF FUTURES TRADING ON PRICES by T. A. Hieronymus

Introduction

A high proportion of the dis cussion about futures trading, particularly at the legislative level, is centered on the effects of futures trading on the level and variability of commodity prices. Generally speak ing, futures trading has been accepted as a useful device for the shifting of risks, securing of financing, and facilitating trade through collection and dissemination of market infor mation, particularly price quotations. Speculators have been accepted as necessary offsets to hedgers but beyond this point they have been generally castigated. Substantial legislative effort has been devoted to limiting the scope of activities of speculators because of their alleged effects on prices and price variability.

The bulk of the opposition to speculators has centered in the Congress and in the CEA. This effort has recently cul minated in the passage of a law prohibiting futures trading in onions. In passing this prohibition the Congress recog nized the extensive use of onions futures as a hedging medium and expressed doubt that the general level of onion prices or the general variation of onion prices was affected but con cluded that there were instances of wild price gyrations, un related to the supply and demand situations, that were caused [121] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR by excessive speculation in onion futures. This conclusion is typical of a long standing congressional attitude.28 It doubt less reflects the suspicious attitude that farmers have long had toward futures markets. The thinking of the Commodity Exchange Authority has been very similar to that of the Congress. Typical is the following comment by J. M. MehL": "It is recognized that in the Commodity futures markets there is need for some speculation. Merchants and processors hedge their inven tories by making short sales of futures against these inven tories and holding the short contracts until the cash com modity is sold. Some of the short contracts of hedgers, of course, are offset by the long hedging contracts of other mer chants or processors whose forward cash sales exceed their inventories. Under most conditions, however, members of the trade as a group are net short in the futures markets. Speculators, by buying the offsetting contracts of hedgers, assume the risk of price changes, and merchants and proces sors thus obtain the equivalent of insurance against price risks, which in turn enables them to operate on smaller margins of Cost ....

"It is not believed that speculation is a basic factor in de termining the general level of prices in the long run. It is believed, however, that an undue amount of speculation tends to make price fluctuations more erratic and at times accentuates price trends. We know from the number and

3 See D. Hearings: Committee on Agriculture and Forestry of the Senate on H. R. 6772, April 1936; Joint Committee on the Economic Report, November 1947; Committee of Agriculture and Forestry of the Senate, February 1948 on S. 1881; Report of the Subcommittee on Futures Trading in Perishable Commodities of the House Agriculture Committee, September 24, 1956. 4Mehl, J. M., Administrator, CEA, before the Joint Committee of the Economic Report, November 24, 1947. [122] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES character of traders entering the market that at times specu lation does have a short-run effect upon prices." A later comment by CEA is in the same vein,25 "After reaching its high of $2-20 per 50-pound sack on February 4, the price of the March future on the Chicago Mercantile Exchange registered a low of $0.85 on March 6. Since that date there has been a substantial recovery with the future expiring on March 22 at $1.58 to $1.60. Price movements such as this cannot be justified by supply and demand factors and must be attributed either to manipulative activity, or, as appears to be the case in this instance, to a wave of exces sive speculation." At the other end of the range are some professional stud ents of futures trading as Holbrook Working, Baer and Sax on, and Henry Bakken.28 These men discuss the stabilizing influence of futures trading in terms of risk assumption at seasons of heavy crop movement that encourages the carry ing forward of inventories, the informed discounting of ex pectations about future developments affecting commodity prices, and the stabilizing influence of a large number of buyers and sellers and a large volume of trading. Economists generally, after rather casual observation, line up in a position rather close to that of Thomsen27, "The most conclusive indictment of futures trading is participation by uninformed traders, both large and small, who make no real effort to evaluate supply and demand conditions but follow market trends and play the psychology of the market.

5 USDA, CEA, Speculation in Onion Futures, January-March 1957, p. iv. "See Working, American Economic Review, May 1949, Baer and Saxon, Commodity Exchanges and Futures Trading, and Bakken, The Theory of Markets and Marketing. 'Thomsen, F. L., Agricultural Marketing, p. 211. [123] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR

The difficulty in rectifying such a condition is in separating the sheep from the goats. "On the other side of the picture, proponents and defend ers of futures trading have claimed that it 'furnishes a con tinuous market' and tends to stabilize prices. But continuous markets exist also for seasonably produced commodities which are not traded on futures exchanges, and there is no proof that the cash markets would not absorb current offerings of grain or cotton in the absence of a futures market. Of course, the inability to transfer risks through hedging opera tions might result in larger handling margins. As for price fluctuations, there are some reasons for believing that they are greater rather than less because of futures trading. Some important commodities not traded extensively on futures exchanges seem to experience no greater fluctuations than do grain and cotton prices. Some analysts have attempted to prove that price variability increases directly with the vol ume of futures trading, but such findings are no more con clusive with respect to cause and effect than the old theory that volume of trading is necessary in order to keep prices stable." In spite of the extensive legislative interest and the many thousands of pages of legislative testimony as well as other literature in substantial volume there has been little attempt made to specifically address the question of the affect of fu tures trading on commodity prices and arrive at a definitive answer.28 This is a truly remarkable state of affairs that does not speak well for the exchanges, the Commodity Exchange Administration, or economists generally. Three steps need to be taken: (1) the speculative pricing

EFFECT OF FUTURES TRADING ON PRICES function of commodity exchanges should be described, (2) the general theory of the influence of speculation on prices should be established, and (3) a system of empirical analysis of the speculative influence should be devised and applied to the question. This paper is a first approximation to this triumvirate of needs. It is far from final. A seminar of this kind here in progress has the disadvantage of exposing one's incompleted work to easy criticism. It has a much greater advantage of getting incompleted thinking out of the files and available for building upon. Speculation The speculative pricing function. The prices of seasonally produced commodities are speculative. The total of the crop is harvested during a brief period of time and is used through out the entire year. Further, varying amounts are carried over from one crop year to the next. There are, in the marketing of seasonably produced commodities, two sources of demand. There is the conventional demand for consumption^ the taking of a continuous flow of product at a series of prices. The rate of this flow (the different quantities taken at different times) depends upon the prevailing prices and upon shifts of the demand schedule right and left through time. The second source of demand is the demand for inventory. There is always present a willingness to hold commodities out of the consumption flow at some price or other. Similarly there is always present a willingness to put commodities into the consumption flow at some price or other. The rate of flow of a commodity into consumption depends upon inter action of the two demands. As the price of the commodity increases, ceterus paribus, the consumption flow is decreased and the flow out of inventory, again all other things re maining equal, is increased. The demand for inventory [125] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR is the short-run supply function and it takes the up-sloping supply schedule form. Accordingly, in the short-run the rate of flow into consump tion, the price is established by the location and slope of the inventory demand schedule. Now, the location and slope of this inventory demand schedule depends upon the expecta tions of inventory holders regarding prices at times in the future. As they anticipate that prices will remain unchanged in the future the schedule remains immobile and prices re main unchanged except as consumption demand shifts. As inventory holders expect that prices will be higher in the future the schedule shifts to the left, forcing prices higher and thus reducing the flow into consumption. As inventory holders expect that prices will be lower in the future the schedule moves to the right lowering current prices and increasing the consumption flow. The propositions are true regardless of whether the intra- or inter-seasonal effects are considered. The bulk of the speculative problem has to do with the rate of flow of products into consumption between harvestsfTiowever, it has also to do with the qrjglliTties that arecarried jorward from crop season To crop_season. As prospective production is reduced, the inventory ~dema^d--^€hjMi3^~sTiifts to jjie left, cutting down the consumption flow and increasing the carryover. The general leveloftTj^price~of_a"commodity in the long run is deTermined by the pr^rnctiOT^Hitffie consumption d^HanoT for the commodity. JjL WP e\r]jj^ie_jheeffert of carr^ffie.r_jdexoand--(or~assu*n«-fch*iVikis_j^mstant) we can say that the season's average price is determined by production and demand for the commodity and- that the season's average price_is--not: TfrerrcdH^y-mventory demand. Thus it becomes clear that, the infl'ttencg-ofhinventory demand is limited to interim prices. It is equall)T^liHrTlTat~invehtory demand is [126] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES of major importance in determining interim price, that is, in determining the pattern of prices about the season's aver age price. Invexitoj^LJialdex^ax^^ Hc-J4dicU^eA-a~m a r k e t position, whether long or short, stands to profit or lose as the price changes. He who takes a market position is influenc ing inventory, either withholding inventory from the con sumption flow if he is long or supplying inventory to the consumption flow at the current price if he is short. And finally, he who influences inventory affects the interim price. There are speculators outside of futures markets, notably producers, merchants, and processors, and there are specu lators in futures markets. Speculators in futures markets in fluence interim prices in proportion to their importance in the total inventory structure. The speculative pricing problem. The problem of specu lators (inventory holders) is to determine the price level at which production and consumption demand will be at equilibrium; the price at which the existing supply will be great enough to last until the next harvest and yet be used down to the necessary carryover level. This is a problem of anticipating well in advance what the supply will be and finally determining what it is after the harvest is complete, of anticipating demand and changes in demand and finally determining what the level of demand is, and of deciding what price will equate supply and demand once they are both known. The problem is not a simple one. The supply situation cannot be accurately anticipated because of the vagaries of production and is never finally known with exactness. De mand for even the simplest of commodities is fantastically complex so that it is difficult to measure. In addition, de mand is dynamic so that the use of historical relationships to [127] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR estimate the level of demand in a given season is extremely difficult. New demand factors continually enter the market and many of them are nonrepetitive. Short-term demand is frequently inelastic so that minor errors of estimate result in major errors in forecasting what the equilibrium price will turn out to have been. The objective of speculative pricing is to estimate the equilibrium price and to adjust inventory activities so that the equilibrium price is immediately achieved and main tained. Such is the theoretical objective. However, it is doubtful that the objective in the real world is this simple. The consumption demand schedule is likely less than a per fect continuum. It is doubtful that consumers, being some thing less than perfectly informed and immediately responsive economic men, react fully to small changes in price so that a price adjustment must be exaggerated to obtain the necessary consumption response. This is, if the price needs to be adjusted upward it must, in the real world, be adjusted upward beyond the equilibrium level to later fall back. This is to say that perfect inventory speculation may result in something other than perfectly stable prices. The futures market speculator. The responsibility for interim price determination is cast upon futures market speculators as a result of the development of futures markets as risk shifting mediums. Futures markets developed out of the need and desire of the holders of cash commodity inven tories to shift the price risks of ownership.28 The way that this process works out can be clearly shown by an examination of the structure of the open contracts.80 Risks are transferred from hedgers to speculators. This process results in the de velopment of very little new ownership risk. The open in-

29 See especially Irwin, H. S., Evolution of Futures Trading. 80 Hieronymus, T. A., Appropriate Speculative Limits on Soybean Oil and Lard, Chicago Board of Trade, 1953. [128] ©1960 Mimir Publishers, Inc. EFFECT OF FUTURES TRADING ON PRICES

terest in futures contracts is of nearly the seme size as the inventories out of producer and government hands. The short hedges, which predominate, are of the same gen eral magnitude as the open interest, spreads subtracted. It is a very interesting phenomenon that futures markets are built on hedging rather than speculation. They do not succeed and persist in the absence of a substantial hedging interest.81 Futures markets are not primarily pricing systems, operat ing for the purpose of establishing speculative prices. Their pricing function is secondary. Speculators in futures markets necessarily influence the prices of the inventories that they control as a result of the risk shifting process. It is an empiri cal fact that they do not go beyond this point except by rath er narrow margins. Such a margin is essential to the liquidity of trading. As risks are shifted to speculators the control of the flow of inventory into consumption also shifts to speculators. The owners of inventory control inventory. The owner of a phys ical inventory that is hedged in futures is not an owner as ownership relates to inventory control. He is a custodian and as such has no influence on the flow of the commodity into consumption. As effective owners, futures market specula tors are important in establishing the location and shape of the inventory demand (interim supply) schedule. The same kind of price influence exercised by long specu lators is also exercised by short speculators. By taking a short position in futures a speculator is committing existing in ventory to the consumption flow at the current price. The nature of his influence is precisely the same as the long specu lator except that it is opposite. Question of influence on price. With the position of the futures market speculator thus in its context of the speculative

alSchonberg, J. S., The Grain Trade, Chapter XII. [129] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR pricing job that must be done, the question of the influence of futures trading on prices becomes: Is the quality of the job of speculative pricing improved or decreased by the activity of futures market speculators? If the objective of speculative pricing is price stability, as we may reasonably assume it to be, the question is: What is the influence of futures market speculators on price variability? But pricing is only one of the two functions of speculators, the other being the assumption of risks. A second appropriate question is: What is the influence of speculative activity on the level of prices? Theoretical Development It is extremely difficult to determine the effects of futures trading on the price of a commodity. The question cannot be subjected to laboratory experiment. The essence of the question is: What average prices and price patterns would have existed had there not been futures trading? There is no doubt that prices vary in the presence of futures trading nor any that they vary in the absence of futures trading. The heart of the question is whether variation is greater or lesser in the presence than in the absence. To finally and con clusively say that futures trading decreases or increases pric es and price variation one must first describe the prices and price patterns that would have existed in the absence of fu tures trading and compare these patterns with the patterns that have actually existed in the presence of futures trading. Methods for such an analysis have not been developed. Two approaches to the question of the effect of futures trad ing on prices can be made. One is logical and the othejrjs empirical. The logical, or theoretical, approach follows. In this consideration five separate areas need to be considered: (1) average levels of prices, (2) interseasonal variation, (3) seasonal variation, (4) month-to-month variation, and (5) [130] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES day-to-day variation. Average prices. Futures trading increases the average of prices received by producers and reduces the average of pric es paid by consumers. Because merchants and processors can hedge they are able to work on smaller margins than they otherwise could. More generally speaking, as futures mar kets enable specialization in risk assumption and risk financ ing, the total cost of these functions is reduced. If speculators in futures markets were not willing to carry risks at a smaller cost than producers, merchants, or processors, hedges would not be placed. Speculators are able to reduce the total of the risks of price change by balancing risks in holding one commodity against risks in holding other commodities. Most speculators trade in more than one commodity. They balance one position against others so that the total of the risks assumed is less than that of the parts separately considered. This is the principle of averaging out that is used by insurance com panies in underwriting risks of loss of life, by fire, etc. The effect of the cheaper cost of risk assumption as the result of futures market is most clearly shown by consider ing harvest sales of producers. Producers sell substantial proportions of all crops at harvest. For some crops as much as 70 percent is sold directly from the fields. These commod ities must move into storage and be owned by agents in the marketing process. In the absence of futures markets they are purchased only as prices are low enough that the risk of loss is reduced to a point at which marketing agents are will ing to speculate. A good illustrative example is found in onions. Prior to futures trading the harvest over-run onions were purchased by merchants at prices low enough that they considered their risks of loss through decreasing prices negligible. They did [131] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR not bid what they thought onions would be worth later, but rather what they were certain were prices that would later be exceeded. That such merchants now pay more than they would in the absence of futures trading is clearly shown by the fact that merchants shift risks by hedging. If they were will ing to assume the risks at as high prices as speculators, they would not hedge. Because harvest time is the peak grower sales period, the weighted average price received by growers is in creased. An active futures market keeps merchants, warehousemen, and processors from preying on producers by maintaining a competitive balance. Merchants and others buy as cheaply ,as possible. The main opposition that they face in their efforts to buy cheaply at harvest is offered by speculators in futures markets. They offer competition to merchants by bidding prices up to levels at which merchants no longer consider commodities cheap and so hedge. In addition, they offer producers opportunities to hedge instead of selling. Futures market quotations are widely disseminated as is all market information pertaining to growing conditions, crop size, storage stocks, rates of use, etc. The existence of futures markets increases the knowledge of producers about market conditions and thus puts them in a more equal bargaining position with purchasers. Insofar as futures trading stabilizes prices it increases the size of the markets for the various commodities. Consumers get more utility from products with stable prices than from those with variable prices. Merchandising programs can be developed better if the supply is regular and the price is stable. The average prices that consumers pay for the end prod ucts of commodities are reduced as the costs of marketing, in this case the cost of risk assumption, are reduced. In this regard the lower costs of marketing resulting from cheaper [132] ©1960 Mimir Publishers, Inc. EFFECT OF FUTURES TRADING ON PRICES risk cost is shared by producers and consumers. The costs of getting risks assumed in the absence of effective futures markets is large. I once reckoned this at 25 to 35 cents per bushel for soybeans.82 That comparable risk pre miums are not discernable in futures markets is a substantial tribute to the effectiveness of such markets in risk reduction. Interseasonal variation. Futures trading can affect the variation in prices from year to year by influencing the size of the carryover of the different commodities from crop year to crop year. Only in rather unusual instances is the size of the carryover out of producer and government hands above minimum levels. Accordingly, futures market speculation has very little effect on annual price variation. Occasionally, as growing conditions are adverse, old crop futures are lower than new crop, encouraging the carrying of hedged stocks for ward. Futures market speculators play an important role in the usual downward adjustment of old crop to new crop prices. Spreading operations of speculators influence the rate at which stocks in commercial inventory are reduced and thus influence the transition of prices. Seasonal variation. The usual seasonal variation in the prices of the different commodities is reduced by futures trading. The long position of speculators builds up to a peak at harvest and is gradually liquidated throughout the season. On the other side of the equation the short positions of hedg ers make an opposite pattern, reaching a maximum at harvest. This maximization of long positions of speculators and short positions of hedgers occurs at the season of the year when downward pressure is greatest and prices are, on average, at the seasonal lows.

Without the inventory accumulation and holding of specu lators, prices would go lower than they do. Someone would buy and hold inventories, but only at prices lower than those at which futures market speculators buy. This must be true because if it were not, futures market speculators would not be the high bidders and thus not able to buy. Futures market speculators do not consume commodities. The inventories that they take off of the market are later 'put back. As they put them back, available for consumption, the price is lower than it otherwise would be. This process of releasing inventory is regular and gradual and proceeds from the time of harvest. The effect of this seasonal counter pressure is to force the price higher at harvest and lower in the winter than it other wise would be, thus reducing the seasonal variation in price. Month-to-month variation. The month-to-month changes in commodity prices are reduced by futures trading. In the jirst_place, the additional market information generated out of the futures mechanism results in a more complete, hence pre sumably more accurate, appraisal of the market factors affect ing price. These are quickly discounted into current prices. The market acts with more foresight, hence more accuracy. If the crop is large so that the rate of consumption needs to be in creased from that of the preceding year, this becomes known early and the price level adjusted. If disappearance is at a faster rate than can be maintained, the price is adjusted upward quickly. Adjustments in price made soon are less extreme than adjustments that are made late. Injhe second place^ the presence of speculators gets market information implemented into price changes that are con sistent with the market information. In the absence of willing speculators the known market facts may not be implemented into price changes or the actual price changes may be in the [134] ©1960 Mimir Publishers, Inc. EFFECT OF FUTURES TRADING ON PRICES wrong direction. For example, if supplies are put on the market by producers for reasons of lack of storage, or funds, or because of taxes and bought by merchants and these mer chants are unwilling to take market positions, the effect may be to depress prices at a time when they should be rising. That is, there is a speculative function that must be per formed. Insofar as market participants are nonspeculators, acting automatically, the speculative function is not per formed. Iri^ the third place, the larger the number of speculators, the more stable will be the price. The forecasting of prices is extremely difficult. Individuals make large errors. Ac cordingly, a large number of judgments results in greater stability than a small number of judgments if the quality of the judgments of the individuals in the large group is as good as the quality of the judgments of the individuals in the small group. Fourth, and finally, speculators in futures markets are logically better forecasters than producers, merchants, etc. In the absence of futures markets, producers and merchants are forced into the business of speculation as a result of their primary production and marketing activities. They may or may not be capable of forecasting and speculating skillfully. If the ability to speculate skillfully is a relatively rare talent, it follows that a rather small proportion of producers and mer chants are capable of skillful speculation. The proportion of this group may be, and probably is, larger than in the popula tion at large, but none the less small. Logically, speculators in futures markets are fairly skillful. Why should barbers, shoe clerks, physicians, lawyers, and housewives be skillful forecasters and speculators? Generally speaking, they are not, but only those who think they are, enter into futures trading as speculators and only those who [135] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR actually are, remain. The unskilled lose their money and quit and the skilled make money and take on a larger role. The business of speculation in commodity futures acts as a continuous spelldown. However illogical it may seem that a particular group of speculators be skilled, the fact is they have to be good to last. Day-to-day variation. Day-to-day price variation is reduced by futures trading. The same forces that are at work to reduce month-to-month price change are also at work in pre cisely the same way to reduce day-to-day price changes. The information attendant to futures trading gets each new change affecting prices discounted into the price structure immediate ly. It is likely that the number of price changes is increased by futures trading, but the size of each change is reduced so that the total of price change is reduced. Futures market trading reduces price changes resulting from automatic actions of nonspeculating merchants. There is a substantial number of merchants who automatically sell upon purchase of cash commodities. In the presence of fu tures markets, they hedge. In the absence of futures markets, "they would be forced to sell to other cash interests. It is clear that because they hedge they can sell at smaller price changes than would result from their sales if there were no hedging facilities. In this connection the liquidity function of futures markets is especially important. In an active futures market there is present a group of traders known as scalpers. These people stand ready to sell at a price moderately higher than the last traded price or buy at a price moderately lower than the last traded price. They accommodate the sellers until buying orders come in and the buyers until selling orders come in. Their actions have a stabilizing effect on price that does not exist outside of futures markets. [136] ©1960 Mimir Publishers, Inc. EFFECT OF FUTURES TRADING ON PRICES

The stabilizing effect of scalpers is limited to the intra-day period. Slightly removed from the actions of scalpers are those of floor traders who perform the same function between days. By absorbing waves of producer and merchant selling until longer term speculator buying enters and by absorbing speculator buying until selling enters, they tend to stabilize prices. The key to a liquid market is a large volume of trading. The greater the ratio of volume of trading to the open in terest, the more liquid and hence, the more stable the price will be. It has been observed many times that as price changes become frequent and substantial the volume of trad ing increases. Most of the persons observing this tendency have concluded that a large volume of trading and much varia tion are associated and some have even gone so far as to sug gest that a large volume of trading causes much price varia tion instead of being caused by the price variation. This read ily apparent short-run association has obscured the longer-run opposite association. Just as in the case of month-to-month price changes, the day-to-day changes are reduced by having a large number of judgments influence the price rather than having a small number. With a large number of participants, the price is~ less subject to individual errors than it otherwise would be. There is an absorbtion of errors effect that has a stabilizing-' influence on price. Possibilities of manipulation. A futures market is less sub ject to manipulation than a cash market. The possibilities of manipulation of futures markets have always been of major concern. However, very seldom has a comparison of the man ipulative possibilities of cash and futures markets been made. Futures trading is subjected to much supervision and regu lation. There is not comparable supervision and regulation

(j)£ cash markets. Futures market positions larger than a cer tain rather small amount must be reported to the Commodity Exchange Authority daily, and positions longer than speci fied amounts are prohibited. It is illegal to manipulate a fu tures market. The practices that are considered manipulative in futures markets are not prohibited or restricted in cash operations. Futures markets are less subject to individual influences than are cash markets. There is a greater concentration of positions in cash markets. The broader the futures market, the less it is subject to the action of individuals. Futures markets are open, public, competitive markets. About the closest approximation to the classical concept of pure competition there is to be found in our economic system is in futures markets. Competition is the antithesis of manip ulation. Destructive influences. Thus far the theory of constructive influences of futures trading on prices have been discussed. There are possible destructive influences; ways that futures trading may add to price variation or distort futures prices from equilibrium levels. Four principal areas should be dis: tinguished. First, cornering or engrossing the supply. In this opera tion a speculator takes a long position in futures in excess of the deliverable supply and buys up or takes delivery on the total supply forcing the shorts to buy futures or cash from him at whatever price he names, distorting the price above ordinary commercial levels. This is not easy to do. It can be attempted only when sup plies are very small. At the conclusion of the corner the spec ulator has a supply of the cash commodity that has cost him more than he can sell it for and on which he loses money. (If he did not overpay for it or hold it too long he has not dis- [138] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES torted the price.) A corner is illegal and the exchanges and CEA watch for this kind of practice and force the speculator to give up the corner before it can be worked. Most of the short positions represent hedges on which delivery can be made. Position limits make a corner virtually impossible. It is extremely difficult to find an effective corner in the modern history of commodity futures markets. A more moderate version is the squeeze in which longs take delivery of all of the supplies at the delivery market forcing shorts to purchase additional supplies and move them into delivery position. This operation can only force the futures price up to the country price plus the cost of putting supplies in delivery position. If the terms of the futures con tract are correct, the futures price should represent the coun try price plus the cost of putting supplies in delivery position. Only a market in which the terms of the contract need adjust ment can be squeezed. The secondjossiWe^distortion is that of bear raiding. Here cash interests put large supplies in delivery position and by tendering and retendering, they force the price down to distress levels. If the cash price is forced below its commer cial value someone will simply take delivery. In a bear raid only...the price at the delivery point is affected^_The outlying price will not follow the futures down. A bear raid can be worked only through continued and vigorous selling and by catching long speculators by surprise. Long speculators watch the delivery situation carefully and are hard to catch. The raider is very apt to have committed himself very deeply below the equilibrium level and suffer a net loss in extricat ing himself. When there is a precipitous decline in the price during the delivery month it is usually because the price is too high to absorb the existing supply. The delivery situation brings [139] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR this fact to light. The real test of whether the situation in futures caused a price decline or not is what happens to the price after futures trading has stopped. Both squeezes and bear raids are thought to exist very much more than they actually do because futures markets are focal points at which underlying forces find expression. It appears that observers frequently look at the direct forces affecting prices without looking at the underlying forces that cause the situation in futures to exist. That is, futures trad ing is taken out of its cash market context and placed in a vacuum for observation. Accordingly there is a tendency to ascribe to futures trading price behavior that is actually the result of underlying economic factors. A good case in point has to do with wheat at Chicago in the spring of 1959. A large and apparently concentrated long interest was built up and, of course, an offsetting short interest. The price increased rather sharply. There was much conversation about a squeeze and how high the price might go. At the peak of the confusion I spent some time in Chicago discussing the situation with interested and informed trade people. The conversations generally had to do with who was long, how much May wheat, how much delivery would be taken, what it would cost to bring in additional supplies, action that the Exchange and the CEA might take, and how large deliverable supplies were in relation to the concentrated long position. That is, the conversation had to do with the technical situation as it existed in the futures market. One could easily gain the impression that this was a battle among futures traders and that their milling and thrashing about was causing substantial gyrations in wheat prices. In the end the prices declined back below the level from which it started. Was this a squeeze that failed? Were these price gyrations [140] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES a product of futures trading? I think not. As I pressed peo ple for their opinions about how the contest that they de scribed would end, those who thought the price would be strong said that the fairly large stocks of wheat in deliver able position would be shipped out for export and those who thought the price would collapse said that the deliverable supply could not be sold out of Chicago because of the limited export demand and comparatively large stocks in more fav orable export position than those in Chicago. In the final analysis the question of the direction of price depended upon export demand. As it finally turned out, the market made an error and the price was bid too high. But had the very uncer tain export demand materialized, the price would have gone on up. The result was the putting of the price about half way to where a vigorous export demand would have forced it. A fairly similar situation existed in wheat in the spring of 1958. In this instance harvest of the new crop was delayed by rain so that old crop supplies had to be stretched out. In the face of large export sales this could be accomplished only by a substantial price rise. In 1958 the outcome of the futures market contest depended on whether or not delivery would be taken which in turn depended on the rate of harvest. I have observed many futures market contests while they were in process and always found that some commercial situa tion of uncertainty lay behind and was responsible for the technical situation in futures. Failure to put futures trad ing in its commercial context and look at the underlying mar ket factors and at the extreme uncertainty of those factors has been responsible for the bulk of criticism leveled at fu tures market speculation. The third possible distortion is what is sometimes called coat tailing! It is a follow-the-leader, movement trading sys tem. It is said that a rise or fall in price feeds on itself. There [141] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR has not been enough study of systems of trading to know how much, if at all, this is a factor. Insofar as movement trading puts the price where it is going anyhow, it is constructive. Only if prices make false starts and frequent reversals of di rection does this kind of activity have a destructive influence. It is doubtful if there is such a thing as movement trading in the aggregate; that is, for everyone who trades with the price movement there is likely someone who trades against it. For every sale there is a purchase. For everyone who thinks the price is going up, someone else thinks it is going down. In this context it is difficult to ascribe much importance to movement trading. The fourth possibility of distortion is that of^ waves of excessive speculation. Speaking of the extreme fluctuations in onion futures prices in late January and early February 1957, the CEA said, "Price movements such as this cannot be justified by supply and demand factors and must be attrib uted either to manipulative activity or, as appears to be the case in this instance, to a wave of excessive speculation," and further, "In summary the rise in onion futures prices in the January 15-31 period was accompanied by a substan tial amount of speculative activity. Large speculators bought net, all futures combined, 166 carlots. Small traders sold net, 485 carlots, and large hedgers had net purchases of 319 carlots. Hedgers, for the most part, were getting out of the onion market by covering their short positions, although there were some new hedging sales in the March future consisting largely of transfers from the February future. The marked increase in the average daily volume of trading in the January 15-31 period further reflected the speculative fervor in the onion futures market."88

EFFECT OF FUTURES TRADING ON PRICES

How much speculation is excessive? How much is just right? How much is too little? For that matter, what is speculation and how is it measured? Speculation is properly measured by the open contracts minus the net of offsetting hedged positions. It is not measured by the volume of trading. One speculates by taking a market position; by being long or short. It is, of course, not possible, but if it were, and one bought and sold the same contracts simultaneously, one would not be speculating; one would neither profit nor lose by his trading activity. One is speculating precisely one-half as much if one buys one contract on Monday and sells it on Tuesday as he is if he buys one contract on Monday and sells it on Wednesday. One is speculating twice as much if he holds two contracts as he is if he holds one contract. At an absolute minimum the amount of speculation must be equal to the net of the hedged positions. If it is at this minimum, the market will be seriously lacking in liquidity and lose attraction for both hedgers and speculators. No criteria have been established by which the ratio of open contracts to the net hedged position should be measured. If this ratio is too small the market will not be liquid. If there is a large speculative position in excess of that needed to as sume the hedged risks, unnecessary risks are created which is, presumably, a wasteful process. There is no reason to think that a larger than necessary speculative position distorts pric es so long as the delivery terms of contracts force the futures market values to reflect the cash trading values. What is the influence of a wave of speculation on prices? Again, it seems well to point out that for every buyer there is a seller; for every long, a short. If a group of speculators descend on a market and take positions, for everyone who thinks the price is too low and will increase, another thinks the price is too high and will decrease. This, in and of itself, [143] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR cannot have any effect on price. Only as speculators change their expectations about the future level of prices and change their market positions in line with their changed expectations are prices changed. The thing, then, that causes prices to change is the changed expectations of market participants. On what are these price expectations based? It is not un reasonable that expectations are in part based on recent mar ket trends. But, again, among our theoretical group of new speculators, there must be an equal number of longs and shorts. For everyone who thinks the price will continue up because it has been going up, there must be one who thinks the trend has gone too far and will shortly reverse. More likely speculators look at the more ordinary factors of produc tion, stocks, and disappearance in forming their price expec tations. If there is a wave of speculative activity, it must show up as part of the open interest. It is interesting to note that in the January-February 1957 period when the extreme varia tion in onion prices was blamed on a "wave of excessive spec ulation" the amount of speculation was actually declining. Examination of the open contracts during the period in ques tion shows a regular and smooth decrease. During the Jan uary 15-31 period, open contracts decreased by 601 carlots. The largest reduction was 407 contracts in small trader long holdings. This is the group that is most often blamed for speculative excesses. They were liquidating positions in a rising market! It is a matter of belaboring the obvious, to suggest that it is doubtful that, inasmuch as there was not a wave of speculation, the price change in question was caused by a wave of speculation. This example appears to take the full measure of the changes about the influence of so-called waves of speculation. [144] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES

Some Empirical Exercises The foregoing discussion of the theory of the effects of futures trading is fairly conclusive. However, the time is long since past when forward steps in search of definitive answers to the relationships of futures trading and price variation should have been taken. Following are some first steps that may be of use as a basis for generating serious work in the area. The general pattern of examination that I have taken to date is to fragment the areas of examination into effects by various time periods: (1) seasonal, (2) month-to-month, and (3) day-to-day. There is no good theoretical reason for such fragmentation. The effects of futures trading are logically the same for all time periods. First, the degree, if not the direction of effects may vary by time periods. That is, fu tures may be better (or worse) discounting systems for dif ferent time periods. Second, the traditional distinction made in much of the literature mentioned at the outset of this paper should be observed in empirical analysis to determine whether such a distinction is justified. The empirical exercises described in this paper pertain to onions. They were selected because I have done more work in this commodity than any other. Seasonal variation. A first step in testing the influence on seasonal variation has been presented by Gray,84 in which he compares seasonal price patterns for three time periods, one before futures trading, a second while the volume of fu tures trading was quite small, and a third since there has been substantial volume of futures trading in onions. I repeated this exercise with the results that are shown in Figure 3. Three nine-year periods beginning in 1931 and

FUTURES TRADING SEMINAR

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EFFECT OF FUTURES TRADING ON PRICES extending through 1958 were selected and an index of sea sonal variation of farm prices of late summer onions was com puted for each of the periods. The last nine years, 1949-58, is the period in which there was futures trading in onions in substantial amount. During the middle nine years there was a very small amount in the last seven and more in the first two. There was no futures trading in onions in the 1931-40 period. The seasonal variation in onion prices was substantially larger in the 1931-40 period than it was in the 1949-58 period. That is, the price went lower at harvest and higher in the spring, before futures trading than it did after volume futures trading was achieved. One thing that may have accounted for the reduction in seasonal variation was the development of an active futures market. But it is possible that other fac tors entered into the reduction. These other factors could have been improved market reporting, improved financial position of onion growers, and better country storage facili ties. Had the difference in seasonal variation been ascribable to these latter three factors the reduction in seasonal varia tion would have occurred gradually over the total of the 27- year period. But it did not. The seasonal variation in the second of the nine-year periods was quite as great as in the first. Thus the reduction in seasonal variation did not occur until the advent of a large amount of futures trading and so must be ascribed to futures trading rather than to other factors. The results obtained in this exercise were consistent with the general theory of futures trading which says that specu lators are better buyers of farmers' commodities at harvest than are cash merchants. The indexes of seasonal variation by periods were as follows: 1931-40 .605 1940-49 .687 1949-58 .348 [147] ©1960 Mimir Publishers, Inc.

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EFFECT OF FUTURES TRADING ON PRICES

The seasonal variation in onion prices was only a little over half as great after futures trading as it was before. r A second measure of the seasonal effect of futures trad- ling is a reduction in the harvest period price depression.88 I divided the September price of cash onions in the Chicago wholesale market by the season's average price and related the resulting coefficient to the number of open contracts in onion futures on September 30 for each of the crop years, 1947-48 through 1957-58. The result is shown in Figure 4. While it is not a close fit there is a marked tendency for the September price to be high in relation to the season's average price as the number of open contracts is relatively large. It is certainly to be expected that factors other than open contracts affect the September average price in relation to the average for the season; left in are all of the errors of fore casting that the market makes. Until such time as we can isolate the factors affecting the making of these errors we must be content with a loose fit. Aj:hirdjtest of seasonal variation was made for onions. The most difficult speculative job with which I am familiar is anticipating the season-end onion situation. Onions are not carried over from year to year so that prices must be such that supplies and use come out even on the day that early spring onions become available. The demand for onions is extremely inelastic resulting in the need for large adjust ments in price at the end of the season as the result of com paratively small forecasting errors made early in the season. The timing of the spring crop is indefinite, being affected by spring weather conditions in Texas. In addition, the sta tistics of existing stocks are less than perfectly accurate. The market attempts to forecast the season's end situa-

FUTURES TRADING SEMINAR tion and discount it back into earlier prices. It does not do this very accurately. But the key question is whether it does it more accurately in the presence of futures trading than it does in the absence. I made some before- and after-futures trading comparisons of the December to March price changes. These are shown In Table III.

Table III. — Change in the monthly Means of Cash Wholesale Prices of Onions at Chicago from December to March

Percent March Percent March Year of December Year of December 1931 80.0 1948 171.4 1932 198.7 1949 90.3 1933 132.4 1950 32.1 1934 93.6 1951 123.6 1935 217.3 1952 168.9 1936 60.4 1953 114.9 1937 175.0 1954 56.2 1938 79.6 1955 75.3 1939 113.4 1956 34.1 1940 190.2 1957 101.5 1941 125.0 1958 185.8 M f33l> M 104.9 In looking at the variation that existed during the futures trading period one can easily understand why it is frequently suggested that onion futures trading does a poor job of dis counting. However, the average December to March change fairly closely approaches zero in the latter period while there is a marked upward change in the earlier period. The means of the changes (deflated) were of the same general order, being only slightly, and not significantly, larg er in the earlier period. However, the summation of the changes squared was .77 times as large in the second period as in the first. It appears that in the second period the forecasting of onion prices was a zero sum game, while in the first there was an upward bias. The price of onions is subject to great varia tion from December to March. The summation of the varia tion does not appear to have been changed by futures; the ex- [150] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES

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FUTURES TRADING SEMINAR tremes of change appear to have been reduced. It is doubtful that the influence of futures trading can be isolated until some of the other influences can be removed. For example, the sharp increase in 1958 was the result of a cold, wet spring in Texas that delayed the crop. This was unforeseeable. The essential problem is to separate the foreseeable and the un foreseeable which as yet escapes me. Shorter-term relationships. Figure 5 is a model of futures trading and price variation. The model was developed from the general theory of the influence of speculation via futures trading on price variation. The parts of the model with which we are most concerned are the center four: price varia tion, open contracts, volume of trading, and the liquidity ratio. The directions of causation were based on the theoreti cal consideration involved. On the left of the model, I have listed six exogenous sources of price variation, factors caus ing price variation that the speculative system must take into account in establishing price. The skill with which this is accomplished will determine, finally, the extent of price variation. Also, exogenous to the system is the stocks in commercial position. The larger the stocks the greater the short hedges; hence, the greater the number of open contracts. The model is primarily designed for description of intra-seasonal varia tion. In this connection, inventory policy of merchants is exogenous to the system. Inventory policies for a given season are established before the price variation within that par ticular season is known. They are, however, based on his torical price variation. The number of floor traders is a function of the size of the futures market which is basically measured by the number of open contracts. Within this framework the number of floor traders (including scalpers) is partially dependent upon [152] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES

the volume of trading; the number affects the volume of trad ing; hence, the dual lines of causation. Within the inner four factors the average of open contracts is the only independent variable. It is a function of stocks and inventory policy. It is only affected by price variation in longer periods than a crop season. Accordingly, lines of causation must run away from open contracts. Such rela tionships as there are between open contracts and price varia tion must be ascribed to open contracts. The size of the speculative market is measured by the num ber of open contracts. The volume of trading is developed out of the existence of open contracts. The relationship of price variation and volume of trading is a dual relationship. Increases in price variation result in more changes in position than occur when prices are stable; speculators have more occasion for changing evaluations of their market positions. The relationship cannot run the other way. Prices can only be affected by position and volume is not position. Volume of trading has an indirect effect on price variation. As the volume of trading is large in relation to the number of open contracts, orders can be executed readily and with small price concessions. Volume of trading is divided by the^ open contracts to obtain the liquidity ratio. If the average of open contracts remains constant the relationship between volume of trading and price variation is both positive and negative. This then is approximately the model that needs to be tested. A meager beginning of testing follows. The first problem encountered in attempting a statistical description of the interrelationships was that of the appropriate measure of price variation. Three different measures were used in examining the variation for the different time periods: vari- [153] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR ance, nonalgebraic change, and range. Variance is a very standard statistical measure that submits nicely to statistical manipulation and that has broad acceptance. Nonalgebraic change is, I think, conceptually better in a futures trading context. There are two conceptual differences between the two measures. Variance measures deviations about a mean and the large deviations are more important than small ones because of the squaring process. Nonalgebraic change is computed by totaling the price changes without regard to sign. It measures the total distance traveled during the time period involved and weights all changes equally. My prefer ence for this measure is that it treats prices as a part of a con tinuum, each price being a function of the preceding price. Prices are a part of a pattern that is usually headed in some direction or other. The deviations about the pattern may well be random. Prices are not random deviations about a mean as the use of variance assumes. Range has a great deal of conceptual merit as a measure of how well forthcoming events are discounted into current prices. It has the major fault that the bulk of the range for a given period may be made in a very short part of the period. Suppose that we are concerned with a season of eight months. Say that during the first month the price falls from $3.00 per unit to $1.00 then recovers to $1.50, still in the same month, and remains in the $1.40 to $1.60 range for the balance of the season. The season's range is, of course, $2.00. But price variation and the quality of discounting is very different than had the price repeatedly fluctuated over the entire range or taken all season to move from one of the range to the other. Linear multiple regression equations were used to examine the relationships. This method precludes the use of the liquid ity ratio in the same equation with open contracts and volume of trading because it is a function of the other two. Obvious- [154] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES ly, volume of trading and open contracts cannot be held con stant while liquidity varies. A system of equations analysis will be required before the quality of the relationship of volume of trading and price variation can be tested. The results of one series of analyses are shown in Table V. Seven different price variation measurements were used; three kinds and three different combinations. These were: (1) X2, the annual average price of onions, the basis being that the level of price affects the absolute magnitude of varia tion, (2) X3, the average number of open contracts, (3) X4, the season's total volume of trading, and (4) Xs, the ratio of volume of trading to open contracts which I call the liquidity ratio. The first pair of equations, seeking to relate the variance of monthly mean prices to open interest and volume of trad ing was without result. The relationship was small and the standard errors of the regression values were very large. So, while the signs of the regression values for X3 were consistent with the model shown in Figure 5, they were of no significance. The second series of four equations relates the total change in price from month-to-month in each season to the four in dependent factors. When the annual average price was in cluded the coefficient of determination reached acceptable levels. The signs of the relationship of price variation to open contracts were erratic and the standard errors again very large. The same observation applies to both volume of trading and the liquidity ratio. The third series of four equations relate the annual range in price to the four independent variables. The positive relationship with annual average price was confirmed. The results with the other three variables were again nil. From these three blocks of equations we must conclude that no relationship between the level of futures trading [155] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR

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FUTURES TRADING SEMINAR activity and the month-to-month change in price has been iso lated. If there is in fact a relationship it should show up in these computations except as it may be very small. This does not mean that futures trading does not affect month-to-month variation. It may be that once the level of futures trading ac tivity exceeds some necessary minimum, additional amounts have no effect. The fourth series of equations relate the net daily variance to the other factors. Net daily variance was computed by sub tracting the variance of the monthly means from the total daily variance. Having found negligible relationship of monthly variance to futures trading I assumed that month-to- month variation was necessary or unavoidable. The ques tion then becomes one of examining the relationship of vari ance that was in addition to the necessary variance. This we can best describe as the unnecessary wandering of the daily prices about the month-to-month deviation. The net daily variance was about 20 percent of the total variance. The results were again inconclusive. The three regression coefficients were negative but the standard errors were very large. The relationship between variance and volume was positive but the standard error was very large. In the fifth series of equations the summation of the non algebraic change from day-to-day minus the summation of month-to-month change was used as the dependent variable. By taking the change in price from the first of one month to the first of the next as necessary or unavoidable change and subtracting the total change within the month, I isolated the intra-month variation for each year that might be affected by futures trading. When the annual average price was included the coef ficients of determination were respectably large. In all equa tions the signs of the open interest regressions were negative. [158] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES

The important change from the earlier experience was that the standard errors were very much smaller. The chances are fairly high that the relationship is actually negative. Conversely they are quite small that the relationship is posi tive. The relationship of volume of trading and price variation was indicated as positive but again the standard errors were quite large. As volume of trading was dropped and the liquidity ratio added to it took the same sign as volume of trading. For the amusement of the seminar and to satisfy the curios ity of those of you who knew that I would eventually be drawn to the flame, I included the results of equation 1.2345 in Table V. If it were but statistically plausible it would be a most interesting result. The coefficient of determination is large, the regression signs are the same as those in the model, and, with the exception of volume of trading, the standard errors are of reasonable size. It is especially interesting to note that, as volume and liquidity were both included in the same equation, the regression values of both increased and the standard errors of both decreased. In the final two sets of equations the total annual varia tion and the total day-to-day change were used as Xi. The results were an approximate combination of the separate examinations of month-to-month and day-to-day variation. In 20 of the 24 equations in which open contracts were used the regression sign was negative. There appears to be a reasonable basis for thinking that as the number of open contracts increases prices become more stable.36 There is no basis for thinking that price variation increased as open con tracts increased.

"There were only minor differences in crop size during the period. [159] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR There was a tendency for the regression values of volume of trading to be positive. They were, however, so unstable as to be inconclusive. The liquidity ratio tended to substitute for volume of trading when it was included. In some of the equations net regression values for the fu tures trading factors were computed. In all instances this was negative, tending to indicate that an increase in the amount of futures trading reduces price variation. To further examine the place of volume of trading it was designated the dependent variable in an equation including X2, average of open contracts, and X3, net daily change in price, the coefficient of determination was .642. The regres sion values for open contracts and price variation were both positive. The result was consistent with the theoretical model. The results of the empirical examination, while not finally confirming the hypothesis that futures trading reduces price variation, make an hypothesis that futures trading increases price variation, particularly in short periods, completely un tenable. Conclusions The over all conclusion indicated by both the theoretical and empirical considerations is that the variation of prices is reduced by an active futures market. Conclusions to the contrary regarding particular markets and commodities must be based on inadequate numbers of contracts or insufficient open interest and volume of trading. Empirical exploration of futures trading in onions indi cates that the price influences ascribed to "waves of specula tive activity" are without any basis. Empirical exploration indicates that there is not a "stabiliz ing influence on seasonal patterns and unstabilizing influence from day-to-day." Quite the contrary, the stabilizing influ ences of futures trading appear to be greater from day-to-day

EFFECT OF FUTURES TRADING ON PRICES than from month-to-month. For my part, we can now bury the textbook notion so long accepted. There are great areas of unknown and unexplained in systems of speculative pricing. A better understanding of the speculative function, criteria for measuring its perform ance, and methods of evaluation need to be developed.

Effects of Futures Trading on Prices Richard M. Withrow It is with a mixture of pleasure and a feeling of respon sibility that I take part in this seminar. It is assuredly a pleas ure to meet with such an impressive group of professors and other speakers. I will be listening hard and hope to learn a lot. I feel a responsibility to see that the practical viewpoints of the grain trade are given consideration in these proceed ings. As a discussant, one can snipe away at the main speak er's contribution from a position of comparative sanctuary, but if I take advantage of this position there is always the question period to help balance accounts. Professor Hieronymus, in the early part of his paper stat ed the topic under discussion. He says the question of the in fluence of futures trading on prices is as follows: "Is the quality of the job of speculative pricing improved or decreased by the activity of futures markets speculators?" To my mind this states the problem except that he tends to limit the activity of the futures market to speculators, while I feel sure he means to include all futures market activity, including hedg ing. He further refines the matter at hand as to what influ ence the futures market speculator has on price variability. Putting the main issue in this form seems to assume that price stability (or a minimum of price variation) is in itself desirable, and that if futures market activity reduces price variation it is necessarily good. Here I take issue. The dis cussion should go one step further than this. Stability ofN prices cannot be set up as an absolutely desirable end in it self. Freedom of prices to fluctuate as long as they reflect basic changes in supply and demand and are fully warranted by economic events is, to my mind, the desirable end. In other words, the discussion of the effect of futures trading

[163] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR on prices should revolve around the point of whether futures trading allows or impedes prices in their adjustment to the economic facts of life. If we say that price stability is in itself the principal aim to be achieved, we are merely seek ing a thermometer that always registers normal, even though the patient may be ill with a high fever, and recognition of the illness and remedial action are really the pressing require ments. Professor Hieronymus is well aware of the importance of price fluctuations to reflect basic economic changes. I quote a small portion of his recent talk in August before the American Soybean Association Convention in St. Louis when he said, in part, while talking about meal prices in the com ing season — "these several considerations point to an increase in meal requirements of about 5 percent, possibly a little more. They indicate a crush of about 425 million bushels. If supplies are not large enough to provide this increase, the price of meal will have to go up to levels that will cut back meal use by hogs." No talk of price stability here but of price change to properly adjust to supply.

While in disagreement with the posing of the question at hand, I am impressed by the persuasive manner in which the main speaker points out the effects of futures trading on av erage prices, interseasonal prices, month-to-month and day- to-day price variations. Claims that futures trading take the wrinkles out of prices seem well substantiated. There have been a number of studies to prove that futures trading al lows the marketing of farm crops at a narrow price spread be tween producer and consumer. In other words, the average price received by producer is raised and the average price paid by consumer is lowered. Likewise, seasonal, month to month, and day to day price variations are reduced.

At the beginning of the paper there is a discussion of the attitude toward speculation and futures trading generally held by government officials, the CEA and students of fu tures trading. There is a notable absentee, and the Professor would have done well to mention the attitude toward futures trading apparently held by the thousands of executives of America's largest corporations dealing in food and fibre — companies such as our largest flour mills, soybean processors, elevators and merchandisers and exporters of grain and grain products, cotton and other commodities — who are free to use or not to use futures markets for hedging protection during the period that they are marketing or processing com modities. I think it would have been well to have mentioned the rather universal use of futures market for price insurance on the part of this large segment of the American economy. A number of studies have been made to test the influence of futures trading on prices. One of the most extensive was completed in the 1920s when a survey of prices for 81 years, including over 100,000 entries, was made. J. E. Boyle divid ed his study into two periods, 1841-60 and 1871-1913. During the earlier period there was no futures trading in wheat, while during the latter period it was an established practice. He found that during the earlier period the average seasonal range in price was 17^, while in the latter period when wheat futures trading was active the range was only 9^. However, there were enough extraneous factors including improved communications, transportation, improved methods of grad ing, etc. that entered into the picture that the results of this study are far from conclusive; and other studies of price rela tionships of the same commodity during periods of futures trading and no futures trading, or studies of similar commodi ties, one of which has a futures market and the other does not, are equally inconclusive. There are many cases where com- [165] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR modities for which futures trading was in effect actually fluc tuated more widely than those for which no futures markets were established. But it is important to point out that fu tures trading often developed for commodities where hedg ing protection was needed due to the inherently large sea sonal price swings in these commodities.

In spite of the fact that most evidence points toward the inconclusiveness of such studies, I just had to get into the act and made a comparison of wheat and rice price variations based on the average price received by farmers for each crop over the past approximately thirteen years. When I picked these two commodities I had no idea what the results would show. You may argue with the choice. They were selected because they are commodities used predominantly for human consumption; they are consumed over large areas of the world. Rice has no futures trading of importance, while well estab lished futures markets for wheat have existed for a long period of time. For the period from August 1946 to and including March 1959 the Average percentage deviation of rice prices was — 10.91% Average percentage deviation of wheat prices was — 5.98% It is unfortunate that our speaker has used the onion mar ket as his example for the purposes of this discussion. The Grain Exchange Institute text book "Grain and Its Market ing" specified four important criteria which make a commod ity suitable for futures trading. The first mentioned is that the product must be durable and suitable for storage over reasonable periods of time without change in quality or de terioration. Secondly, the commodity must have adaptability for grading into distinctly and definitely standardized classifi cations. Third, the product should be one which is produced seasonally, necessitating storage over a period of time for or-

EFFECT OF FUTURES TRADING ON PRICES derly marketing, and fourth, the product should be produced by a large number of producers and used by a large number of consumers. Many commodities admirably meet all of these tests but, unfortunately, this is not true of onions. Now to return again to this fetish that is sometimes made of stability of prices and the apparent enthusiasm for small price variation. We can sit around and hope that supply and demand factors will be such that price changes between seasons, during the season, on a month-to-month or day-to day basis may be small, and thus industries, merchandisers and exporters, etc. may carry on their activities with a mini mum of mental strain. However, often times price changes must be violent to awaken new demand or attract supplies, as your main speaker has pointed out, and I quote, "It is doubtful that consumers, being something less than perfect ly informed and immediately responsive economic men, react fully to small changes in price, so that a price adjustment must be exaggerated to obtain the necessary consumption re sponse." There is plenty of historical evidence to point out that the price of any commodity in common usage will, un der conditions of short supply, rise by a different ratio from the percentage relationship of supply to the normal or aver age; and, conversely, when the supply of a commodity is in excess of normal requirements, the price will decline more than the percentage relationship of the supply to the normal requirements. Gregory King observed this phenomenon dur ing a series of famines in England and embodies his observa tions into what has come to be called "Gregory King's Law of Prices."

Note that your main speaker has remarked on the fact that futures trading often increases as a result of large price changes. This can be observed in the day to day activities [167] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR of the Grain Exchange where above normal price changes are frequently accompanied by increases in the volume of trading. Let's face the facts — the average speculator is in terested in trading in a commodity that moves. If oats are fluctuating within a range of i/4 to \/2 cent and soybeans have a range of 2 to 3 cents per day, the speculation is going to be attracted to the soybean market. In this case it is obvious that accelerated futures trading is not the cause of wide price swings but is the result of the wide price swings. I am glad ,that Professor Hieronymus has pointed out that the elimina tion of futures trading does not eliminate speculation. His "mention of the speculation that takes place in cash markets and the fact that cash markets are unregulated, whereas fu tures markets are subject to tremendous regulation, is a most welcome contribution in this discussion. We have all heard of the farmer who produced a crop of wheat or soybeans and, when confronted with the idea of hedging his products in the futures market and waiting for a more favorable basis to sell his cash crop, abhors the idea on the grounds that to trade in the futures market is "rank speculation." Meanwhile, he sees nothing inconsistent with carrying an unhedged crop for a long period of time. Now I have wandered a little bit in attempting to com ment on the main speaker's paper and, of necessity, have injected some of my own ideas. It is time here to say that I am in general agreement with Professor Hieronymus' conclu sions with the exceptions already noted. I have tried to stress the point that price variation is not evil if it is the logical outcome of changing economic forces. Now the question arises — is there excessive price variation that is the result, not of supply and demand fundamentals, but rather the re sult of excessive speculation or faulty futures trading. I do not know any way in which one can prove that futures trad- [168] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES ing does not distort the normal flow of prices as they would be shaped by economic events. My own experience of some twenty-one years of close association with grain marketing on the Chicago Board of Trade is that price distortion, as a result of futures trading, or speculative activity, if you prefer it, is infrequent and, where present, is a factor over the very short run only. It is interesting to note the conclusion of the CEA in their study "Speculation in Onion Futures — January to March 1957" in which they stated as point §8 in their summary and conclusions as follows: "It is clear that futures trading in onions has widened and accentuated price movement of short periods of time within a marketing season. Price behavior since January 8, 1957, is an example. No evidence has been found, however, that would justify the conclusion that the average season prices received by producers for cash onions have been materially affected by futures trading." In this regard I quote the following from "Futures Trading on Or ganized Commodity Markets in the United States" by G. Wright Hoffman, former professor at the University of Penn sylvania and consulting economist for the USDA: "Futures prices do serve to indicate, when compared with spot prices, the probable course of prices in the future, but conditions change rapidly so that it is doubtful whether any effective discounting or forecasting is done beyond the limits of a very few weeks. It is doubtful too whether the focus of trading in terest by speculators as a group fall much beyond two or three weeks ahead." When first apprised of the subject matter to be discussed, namely the effect of futures trading on prices, and before I had a chance to read your main speaker's paper, the events surrounding futures price changes in wheat during the spring of 1958 and again in the spring of 1959 came to mind, and [169] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

I was interested that Professor Hieronymus also used these situations in his paper. He stresses the point that the cash wheat situation was the basis for futures activity in both of these instances. You will recall that wheat futures rose in the spring of 1958 — in fact the May wheat went off the Board at the season's high. Large elevator and merchandising inter ests were heavily on the long side of the futures market in that case, with cash wheat sold for export. Here was a situa tion in which the demand for export actually existed, the har vesting of the new crop was delayed by rain, and thus the economics of the situation called for a price rise and it was substantial and sustained. In the spring of 1959 the March and May wheat futures were also in an up-trend that began about late December but here, however, the dominant long represented large speculative holdings and the export busi ness that they hoped for failed to materialize. Thus a preci pitous drop in prices occurred about mid-April. Futures ac tivity was rather heavy in both cases and, while some short-run distortions may have taken place, prices of futures contracts bowed to the inevitable and conformed to the essentials of the cash situation. I believe that you could take any number of seasoned futures traders, cash grain handlers, and others di rectly concerned with prices of commodities actively traded on futures exchanges, and they would agree to a man that, while the effects of futures trading might at times cause some short-run price variation not consistent with the law of sup ply and demand, over any extended period prices established by futures trading must be such as to be fully warranted and justified by the fundamentals of the cash grain situation. We have recently had a very good example of the adjustment of futures values to known cash grain statistical factors. Prior to the August 11 government crop report last month, there was widespread feeling among traders that the soybean crop

EFFECT OF FUTURES TRADING ON PRICES estimate would be down in reflection of drought conditions suffered in the main belt in early July. In fact, if my memory serves me, the average guess of a number of Board of Trade members was 511 million bushels. However — when the re port was released the soybean estimate was 531 million bush els. The drop in bean prices the following market day, Oc tober 12, was nearly 6 cents, with closing prices 414 to 43^ lower for the day, and subsequently prices drifted still lower. I submit that speculators may have wished the market higher, but wishing could not make it so in the face of the govern ment's production estimate. Quoting again from the main speaker, "it is extremely dif ficult to determine the effects of futures trading on the price of a commodity. The question cannot be subjected to labora tory experiment." In spite of this clear statement, our main speaker launches into a group of what he calls "linear mul tiple regression equations," in connection with his model of futures trading and price variations reproduced in Figure 5. Rather than becoming critical of this approach to the problem I am going to defer to the other discussants whom I hope can approach this part of the talk with a greater insight than I — only to say, if we are to provide readable material for peo ple who are interested in the effects of futures trading on prices we must use a more common approach to the subject. It appears to me that my good friend Tom, in the latter part of his speech, is guilty of a certain amount of virtuosity. By page 154 in the speech it was evident that here was a man who, when asked "what time is it?" proceeds to tell how the watch is made. In summary, although being harsh at times, I am in gen eral agreement with friend Tom's conclusions. Along the way he has dropped a number of gems. For example, his comment that the "business of speculation in commodity fu- [171] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR tures acts as a continuous spell-down" is so apt in describing the continuous erosion that takes toll of commodity specula tors, while at the same time, more skilled operators make money and assume a larger role in the market place. I have two main points I would like to leave with you. The first one is that I believe that variation of prices is not to be scorned if it is consistent with the fundamental economic forces at play. Freedom of prices to fluctuate, unimpeded by restraints, ceilings and floors, in their continuing effort to reflect the balance between supply and demand, is essen tial. The government, in its price support philosophy (in cluding the impositions of ceilings after the war) shows too great a reverence for price stability — as embodied in the now disputed parity price concept. The shrewd retail merchan diser is not so bound by the idea of fixed prices. When he has a surplus he has a sale, cuts prices drastically and clears the shelves. The second point is that when futures trading influ ences prices in an opposite direction from the fundamental factors in the cash market it is normally for the short-run only.

It has been a pleasure to participate in this seminar. Thank you for your attention.

Effects of Futures Trading on Prices Reynold P. Dahl Professor Hieronymus points out that his paper is a first approximation to three needs, namely, a description of the speculative pricing functions of commodity exchanges, the establishment of a general theory of the influence of specula tion on prices, and a system of empirical analysis of the speculative influence. Few would argue that these objectives are not worthy. It is fortunate, however, that he admits his paper to be "an approximation" that is "far from final". He further qualifies the paper by stating that his work is in complete and, hence, is open to easy criticism. Although my comments contain some elements of cri ticism, as the author anticipates, such criticism is made in good faith in hopes that it may be useful in strengthening his final product. The quote from J. M. Mehl which Hieronymus cites in the opening paragraphs of his paper does not warrant his conclusion that the Commodity Exchange Authority is against the speculator. The Mehl statement is reasonable and I'm sure many, including myself, would be willing to accept it as fact. Certainly there is little in this paper which would dis prove it. In fairness to Mr. Mehl a quote from his statement in the hearings on futures trading in onions is appropriate. "I appear in behalf of the Chicago Merchantile Exchange in opposition to the pending bills to prohibit trade in onions for future delivery. As you might expect, I have over the years acquired certain personal convictions regarding the economic value of organized and orderly speculation in agri cultural commodities. One such conviction is that construc tive and orderly speculation is possible only through the medium of trade in contracts for future delivery."37 37 Onion Futures Trading, Hearings: Committee on Agriculture and Forestry United States Senate, 85th Congress on S.778, S.1514, and H.R. 376, Part 2, March 20, 21, 24, 25 and 26 1958, p. 277. [173] ©1960 Mimir Publishers, Inc.

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Hieronymus points out in his discussion of the speculative pricing function that there are two sources of demand in the marketing of seasonally produced commodities, namely, the conventional demand for consumption and the demand for inventory. He goes on to say that "the demand for inventory is a short-run supply function and it takes the up-sloping supply schedule form", and "in the short-run the rate of flow into consumption, hence, the price is established by the loca tion and slope of the inventory demand schedule." I have difficulty in understanding how a demand schedule can take the form of a supply schedule. Hieronymus seems to be writ ing new theory in this section of his paper without regard to the internal consistency of the theory. His statement that "inventory holders are speculators" is difficult to reconcile at a seminar where the economics of futures trading are being analyzed. Major roles played by a futures market are to make it possible for inventory holders to minimize price risks and to facilitate the economic distribu tion of supplies through time. A futures market performs these functions through the hedging medium. Hieronymus' discussion of inventory demand would have been less "fuzzy" if it were related to cash-future price rela tionships. I'm sure he recognizes that merchants and proces sors look to cash-future price relationships as a guide to their storage operations, although direct reference to this point is not made in his paper. It is useful to consider the difference between the cash and futures price as representing the price of storage. A positive price and hence a positive return can be earned from storage when the futures price exceeds the cash price. When the cash price exceeds the futures price storage has a negative price and hence earns a negative return. These results are predi cated on the principle that the cash and futures prices equalize [174] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES during the month of delivery. When supplies are abundant they are reflected in the market through positive carrying charges, which in turn induce merchants and processors to carry these stocks forward. When supplies are scarce, how ever, inverse carrying charges discourage the carrying of stocks. This reasoning appears to have escaped Hieronymus. His concept of "inventory demand", considered without ref erence to cash-futures price relationships, is meaningless. Working states the economic significance of the price of storage as follows: "It is through supplying a direct measure of the return to be expected from storage, and a means, through hedging, of assuring receipt of that return, or of approximately that return, that a futures market makes its most direct and powerful contribution to the economical dis tribution of supplies of a commodity over time."38 Further in his "description" of the speculative pricing of commodity exchanges, Hieronymus makes the statement that futures markets are not primarily pricing systems, operating for the purpose of establishing speculative prices. Their pric ing function is secondary." It is not clear from his subsequent discussion what the major role of a futures market is if it is not pricing. Perhaps the author did not intend for this state ment to be taken literally or had some other point in mind which he did not clarify in his paper. Most students of futures trading certainly recognize that pricing is the major func tion of a futures market. One competent student has stated that "The business of a futures market, so far as it may dif fer from that of any other, is to anticipate future developments as best it may and to give them due expression in present prices, spot and near futures as well as distant futures."39

38 Holbrook Working, "The Theory of Price of Storage", American Economic Re view, Vol. XXXIX, No. 6, December 1949. 39 Holbrook Working, "Theory of the Inverse Carrying Charges in Futures Mar kets," Journal of Farm Economics, Vol. 30, No. 1, February 1948, pp. 14-15. [175] ©1960 Mimir Publishers, Inc.

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Several statements made by Professor Hieronymus leave the impression that futures market speculators buy and sell commodities as well as contracts. For example, "Without the inventory accumulation and holding of speculators, pric es would go lower than they do. Someone would buy and hold inventories, but only at prices lower than those at which futures market speculators buy." I'm sure he recognizes that futures market speculators deal in contracts and do not accumulate inventories in their capacity as speculators. They offer competition to merchants only by making it possible for other merchants to reduce their price risks through the medium of hedging. The author also draws the conclusion, without supporting evidence, that "speculators in futures markets are logically bet ter forecasters than producers, merchants, etc." He submits the qualification that the "unskilled lose their money and quit and the skilled make money and take on a larger role." While it is true that the unskilled who lose will quit, is there not also good reason for believing that others will take their place. One study led to the conclusion, as a statement of historical fact, that "speculators in wheat futures as a group have in the past carried the risks of price changes on hedged wheat and have received no reward for the service but paid heavily for the privilege."40 His statement that speculators are better forecasters than producers, merchants, etc., also reflects an inadequate view that hedgers are mere risk-shifters who have no price ideas. A speculator who finds himself outsmarted by a soybean crusher — a not unrealistic example — would be able to muster at best a wry smile at being informed that he is "logically a better forecaster than a hedger."

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The paper indicates that the author has a keen apprecia tion for the importance of adequate speculation to a well- functioning futures market. He also recognizes the absurdity of some of the charges about too much speculation; but he deplores the absence of criteria for judging the adequacy of speculation. In this connection it is interesting to note that Roger Gray provided such criteria in his paper yesterday. So what one of the speakers has pointed out as being needed another speaker has provided. This certainly represents nice coincidence. In his analysis of the influence of a wave of speculation on prices Hieronymus reasons as follows: "For every buyer there is a seller; for every long, a short. If a group of speculators descend on a market and take positions, for everyone who thinks the price is too low and will increase, another thinks the price is too high and will decrease. This, in and of itself, cannot have any effect on price." This statement and various paraphrasings of it seems to imply that prices cannot change, since every time someone wants to buy there is someone want ing to sell and these forces necessarily cancel out. Since pric es do change in futures markets, such reasoning is fallacious and can hardly be cited as evidence that speculation cannot affect prices. In his "empirical exercises" where Hieronymus studies the effect of futures trading on onion prices, he verifies Gray's analysis which shows a reduction in the seasonal price variability in onions since futures trading in onions became an important factor in marketing. This is a significant con tribution to the economics of futures trading because it is the first time that such a beneficial effect of futures trading has been demonstrated. A second measure of the seasonal effect of futures trading on onion prices where he relates the September price of cash [177] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR onions divided by the seasons average price of onions to the number of open contracts does not show anything not re vealed by the analysis of seasonal price variability in the three nine year periods. The relationship here is not close, as he points out, and this "exercise" may detract attention from the previous measure of seasonal influence. From his analysis of the ratio of the March to December price changes in onions before and after futures trading he concludes that the forecasting of onion prices appears to be a zero sum game during the period of futures trading. I don't quite see why this should be the case. In fact, it shouldn't be a zero sum game because it does cost something to carry onions from December to March. When Hieronymus turns to the analysis of the effects of futures trading on intra-seasonal price variability he "shifts gears" and resorts to multiple regression analysis. This is difficult to understand because the same technique used in the analysis of seasonal price variability could have been used in studying day-to-day and month-to-month variability. Would it not be interesting to compare the day-to-day, week- to-week, and month-to-month price variability between the same three nine year periods used in the seasonal analysis? In the model which the author sets up on the interrela tionships between futures trading and intra-seasonal price variability he considers such factors as changes in produc tion, timing of the new crop, and the level of stocks as exogen ous variables and hence does not include them in his re gression equations. Certainly he recognizes that these are major variables that tend to induce price variability and they cannot be ignored just because they are considered exogenous in his model. It is not surprising that his regression coef ficients were low and the standard errors high with the variables used.

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He reasons that variations in commercial stocks are ac counted for in his regression analysis through variations in open contracts. While it is true that open contracts vary di rectly with stocks in commodities where futures markets are used extensively for hedging, this association in onions may be imperfect because many onions are not hedged. The reader may be puzzled, with some justification, as to why so much attention is given to onions in this paper rather than to better established and better organized fu tures markets such as that in wheat. After all, most would agree that onions are scarcely a good example of highly de veloped futures trading. Why pay so much attention to them? The only reason advanced by the author is that he has done more work in this commodity than any other. It would have been appropriate to point out that onions are a particularly fruitful topic for research. Since futures trad ing in this commodity is of recent origin, one can study price variability before and after futures trading to ascertain chang es. To the extent that changes are observed, it is reasonable to ascribe them to futures trading if they cannot be explained by other factors. If certain price effects of futures trading in onions can be isolated, it is reasonable to ascribe these same effects to futures trading in other commodities. This would be an important contribution in the understanding of the economics of futures trading. In conclusion a few remarks aimed at redirecting our at tention to the basic problem under discussion in this paper are appropriate. As I previously mentioned, Professor Hie ronymus has done a good job in pointing out the importance of speculation in futures and in calling attention to the need for criteria to judge the adequacy of speculation. He has also discussed some "destructive influences" such as squeezes which may tend to distort prices and add to price variability. [179] ©1960 Mimir Publishers, Inc.

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However, he does not feel they are important because they are usually explained by some commercial situation of un certainty. Further analysis of such influences is needed. Fu tures markets may not be perfect and ways of improving them should not be overlooked. In analyzing the problem under discussion in this paper, accepted theory and previous research results are useful as a guiding framework. The author has not drawn upon such material as adequately as he might have. A review of this paper supports the author's admonition that it is "an approxi mation" that is "far from final".

Effects of Futures Trading on Prices Geoffrey Shepherd Tom says in his paper: "Two approaches to the question of the effect of futures trading on prices can be made. One is logical and the other is empirical. The logical, or theoreti cal, approach follows." After that comes the empirical ap proach. The "logical or theoretical approach" turns out to be a series of sections, each one beginning with a categorical con clusion concerning the effect of futures trading on prices. The first section, for example, starts out: "Futures trading increases the average of prices received by producers and reduces the average of prices paid by consumers." The rest of the section consists of Tom's opinions in support of this conclusion. Another section starts out: "Day to day price variation is reduced by futures trading," although he points out later in this section that "as price changes become more frequent and substantial the volume of trading increases." No statistical facts are adduced; this is all, as he says, theoreti cal. The other sections follow the same pattern. But then, about half way through the paper, the author tells us that the preceding pages have given, not the theory of the effects of futures trading on prices, but "the theory of constructive influences of futures trading on prices." He gives us next the theory of "destructive influences; ways that futures trading may add to price variation or distort futures prices from equilibrium levels." Again there comes a series of assertions as to how this may be done, but in this case the opinions and arguments which follow are designed to de molish the assertions. If conclusions could be substantiated by armchair theoriz ing of this character, the author could have stopped right

FUTURES TRADING SEMINAR there, although that would have left the reader with an un comfortable feeling that he had heard only one side of the case. But Tom goes on and devotes the rest of his paper to "some empirical exercises." If his theory is based on facts, it does not need further empirical exercises to support it. If it is not based on facts, it is not a theory but only a collection of hypotheses to be tested empirically against the facts. Scientific method starts out, not with conclusions to be supported, but with hypo theses to be tested. So the best we can do is to say "Well! Tom has given us some hypotheses, not conclusions. Let us see how they stand up under the empirical tests he speaks of." Empirical Exercises Effects of futures trading on seasonal variation. Tom re produces Gray's chart which shows that the seasonal varia tion in onion prices after World War II was only a little over half as great as it was during the war and before the war. He realizes that other things than futures trading were happening too, and could have caused this reduction; but he ascribes it to futures trading. This post hoc ergo propter hoc kind of analysis can be quite misleading. When a dozen or more factors are affecting pric es, and you are interested in only one, it is a natural mistake to ascribe the change in prices to the factor you are interested in. But another investigator will as naturally ascribe it to a different factor that he is interested in. Both cannot be right. A few years ago, one of our most respected agricultural economists, Elmer Working, found a reduction in the varia tion of corn prices after the war.11 But he was interested in the effects of the CCC loan program, so he ascribed this re-

EFFECT OF FUTURES TRADING ON PRICES duction to the loan program. It didn't occur to him that futures trading might have been the reason and, as a matter of fact, it probably wasn't. In fact, shifting what he called "the post-loan period" (and which Tom would call instead "the futures trading period") by only one year showed that the post-war variation was almost as great as the prewar varia tion after all. The before-and-after method is not reliable in cases like these. Futures trading in onions may well have reduced seasonal price variation after the war. But Tom ad duces no evidence which shows that it did. The same sort of thing is true of Tom's Table IV. It shows the effects of all of the dozen or more factors that affected onion prices, but Tom implies that the reduction in price variation was all due to futures trading. The data actually do not support what Tom claims. He says that the extremes of change appear to have been reduced; but the extreme (range) in the "pre-futures" period was 156.9, and in the "futures" period, 153.7 — a reduction of only 2 per cent — certainly not statistically or otherwise significant. Further more, the high ratio for 1958 does not fit in with his pre-conception that futures trading reduced price change, so he ex plains it away by a cold wet spring in Texas; but he does not do this for any of the "pre-futures" years, when undoubtedly Texas had much the same climate as it had after futures trad ing in onions began. The seasonal variability of egg prices decreased to less than half their prewar variation, as onions did. Tom might ascribe this to increased trading in egg futures. I would be more in clined to attribute it to the reduction in the seasonal variation of production that took place, or the increase in the storage of frozen eggs at a lower cost than for shell eggs. I suspect that similar non-futures factors accounted for a good deal of the decline — perhaps all of it — that took place in the seasonal

[183] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR variation in onion prices. Just for fun, I looked up what happened to hog prices over these years. The average variation for hogs decreased from 116.9 in 1931-41 to 106.5 in 1948-58, a reduction of 10 per cent. I would not ascribe this to an increase in futures trading. Simple Correlation Study Tom's Figure 4 shows some positive correlation between the harvest period depression and the number of open con tracts on September 30th. He calls this a "marked tendency", and concludes that the open contracts are one of the factors that reduce the harvest period price depression. Now actually, correlation tells us nothing about causation or the direction of causation. One could equally well draw the opposite conclusion from this study — that a large harvest period price depression causes an increase in open contracts. But neither conclusion would be justified merely by the cor relation. In any case the relationship is too low to be significant. It is not significant at the 1 per cent level, and is only signifi cant at the 5 per cent level. If one dot (No. 9) is omitted, the relationship decreases- greatly; it is non-significant then at both levels. We have seen so many correlation studies, with high correlations (significant at the 1 per cent level) fail to stand up, that we would like to warn Tom against rely ing on the result of a study that is not significant, or whose significance depends upon only one dot. Multiple Correlation Study Tom makes a real attempt to use scientific method in the last part of his paper. He sets up hypotheses in the form of a model and proceeds to test it by multiple correlation analy sis. His model is one of many different models that could be set up. Other investigators would be likely to think up dif- [184] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES ferent models to test. But without raising questions here about his choice of factors and measures of variation, let us go along with his model and see how it tests out. His Table V shows that the first 3 groups of equations, as he says, show no relation between futures trading activity and month-to-month change in price. The fourth group, showing net daily variance, also yields inconclusive results. The last 3 groups, dealing also with day-to-day price varia tions, yield large positive regressions with annual price, small negative regressions with open interest, and still smaller posi tive regressions with volume of trading. One might conclude incautiously from this that high an nual prices have a strong tendency to unstabilize prices, open commitments have a small tendency to stabilize prices, and trading has a still smaller tendency to unstabilize them. But Tom ignores the large regression with annual price, and bases his conclusions only on the small regression with open interest. This is odd, because when you look at the size of the 15 X 3 (open interest) and X 4 (volume of trading) regres sion coefficients/2 you see that almost all of them are so small compared with their standard errors that they are statistically insignificant. This is not a matter of judgement, but of stand ard statistical tests. A coefficient must be 2 or 3 times as large as its standard error before it can be considered statis tically significant. Only one of the 15 is twice as large as its standard error; none of them is 3 times as large. Two of the open-interest regressions, where the average price variable is left out, are only one-tenth of 1 per cent as large as their standard errors. The standard errors of the volume of trad ing regressions are fantastically large. These things mean that "This omits the coefficients for equation 1.2345; as Tom points out, it is not reliable, because it includes one variable which is the quotient of two of the others. * [185] ©1960 Mimir Publishers, Inc.

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Tom has been unable to show any relation between day-to day variation in prices and open interest and volume of trad ing, much less any causation. Thus his analysis contradicts his own earlier flat conclusion that day-to-day price variation is reduced by futures trading. Only 9 of the 24 equations in Table V show statistically significant R2. A study including 4 variables, each with only 11 items in the series, has only 7 degrees of freedom. In that case, according to the standard test of statistical significance, any R2 less than 0.44 is not significant. Only 4 of the 24 R2 are higher than 0.64, the level regarded as highly signifi cant, and those 4 only barely exceed this figure. When you look at the size of the betas in Table 2, you see that nearly all of the size of the R2 results from the one factor, the annual average price, which Tom ignores in his conclusions. When this factor is left out, the R2 are all smaller than 0.5, and some are smaller than 0.3. So the most the table indicates is that high price variation goes along with high annual prices. This tells us nothing about the effects of speculation. These tests of significance apply to random data (to sam ples of independent data taken at random from the same universe). Economists recognize that economic time series are not random. So an analysis including economic time series, like Tom's here, is still less significant than the tests indicate. G. U. Yule got a correlation of 9.95 between Church of England marriages and mortality rates over a period of 45 years, for which anything over 0.29 would be significant; but as he pointed out, all he really had, "in non-technical language, was a fluke"." We need to remember also that a correlation coefficient shows only relation, accidental or otherwise. It does not show 43 G. Udny Yule, "Why Do We Sometimes Get Nonsense Correlations Between Time Series?" Journal of the Royal Statistical Society, Vol. 89, No. 1, 1926, pp. 1-64. [186] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES causation. One may choose price variation as the dependent variable; this does not make it the dependent variable in actual fact. The same variables could be set up in reverse order, with volume of trading as the dependent variable. Tom does this later in his analysis, and comes out with an R2 about as high as any he got in his Table 2. This does not prove that the other factors cause the volume of trading. Similarly, Tom's study does not prove that the factors he selects affect prices, especially when his coefficients are so low. You can get high positive correlations between school children's writing ability and the size of their feet, but that doesn't prove that size of feet affects writing ability, nor does it prove that writing ability increases the size of the writer's feet; it only indicates that some other factor, in this case, age, affects both. Similarly, you can get high correlations between the number of storks in European towns and the number of babies born; but I can't believe that this proves that the babies were brought by the storks.44 Correlation does not prove causation, even when the coef ficients are high, and certainly not when they are low as they are here. Tom's conclusions are quite unsupported by his multiple correlation analysis. In fact they are contravened. His analysis shows no significant relationship between futures trading and price variations, and no causation at all. But he ignores this, and concludes first that "the variation of prices is reduced by an active futures market"; and second, "that there is not a stabilizing influence on seasonal patterns" (which doesn't fit well with his earlier conclusion that specu lation reduces seasonal variation); and third, that "there is no unstabilizing influence from day-to-day". Tom's conclusions are partly inconsistent, and in any case, he has shown no evi-

FUTURES TRADING SEMINAR dence which supports them. L. D. Howell's conclusions, which are similar to the conclusions reached by several other careful and impartial analysts, and by Mr. Withrow just now, are that futures trading "increases the frequency of changes in grain prices and may at times increase the amounts of these changes over relatively short periods."45 This conclusion remains unscathed. Like Mark Twain, the reports of its death and need to be buried have been grossly exaggerated. The "Wave of Speculation" in 1957 Tom says that there was not a "wave of speculation" in the onion market in January and February of 1957. He says that "if there is a wave of speculative activity, it must show up as part of the open interest", and concludes that in January and February "the amount of speculation was actually declining", because the open contracts were de clining. Table VI shows that actually it was only the open interest

OPEN CONTRACTS Table VI (In carlots) Future Date 1957 1957 1957 1957 Total Feb. March Nov. Jan. 1957 January 15 1,037 2,587 19 »3,861 January 31 417 2,795 48 3,260 February 1 332 2,508 48 2,888 February 6 113 2,877 65 3,055 February 7 86 2,819 65 2,970 February 15 6 2,626 120 2,752 February 28 1,437 208 14 1,659 March 6 741 293 16 1,050 March 15 255 440 35 730 March 22 43 527 66 636 1 Total includes 218 carlots open in 1957 January future. Source: "Speculation in Onion Futures, January-March 1957", United States Department of Agriculture, Commodity Exchange Authority, Washington 25, D. C. Page 5.

EFFECT OF FUTURES TRADING ON PRICES in the February future that was declining. I don't know what else one would expect, since February, the delivery month, was at hand. The open interest in the dominant crop-year-end March future was rising, not declining: it reached a peak on February 12th, by which time prices were past their peak. In any case, I cannot follow Tom in his flat statement that speculative activity must show up as part of the open in terest. The facts of the matter do not seem to follow him either. Speculative activity consists of buying and selling, or in one word, trading. The best measure of the volume of trading I know of is the volume of trading. Figure 3 shows that the volume of trading increased several times over dur ing the period. In view of the simple facts of the matter, I do not see how Tom can conclude that the price change could not have been caused by a wave of speculation because there was not a wave of speculation. Clearly there was a wave of speculation, and clearly there was a sharp rise and subsequent decline in prices, at the same time. Both are shown in Figure 3. I am not going to fall into Tom's er ror and conclude merely from this correlation that the one was the cause of the other. But the positive correlation be tween the two is obvious. I wish I could express more agreement with Tom's paper, for we are good friends and colleagues. But it really would be no kindness to a man just to pat him on the back and not point out weak spots in his car, so that he can strengthen them before he gets out on the highway, and it is in this spirit that I offer my comments. At least, I am relieved to be able to close on a note of agreement with him. I can agree completely with the last sentence of his conclusions: "A better understanding of the speculative function, criteria for measuring its performance, [189] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

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EFFECT OF FUTURES TRADING ON PRICES and method of evaluation need to be developed." I hope Tom and others will develop them. Much competent work has already been done; I hope that more will follow, to show more clearly what kinds of specu lation stabilize prices, what kinds unstabilize them, and how the one can be sorted out from the other. As I have shown elsewhere,46 speculation can be a stabilizing and margin-nar rowing force. I hope that Tom and others will continue their studies to this end, and show how the performance of the futures market can be still further improved. I hope that these studies will include such new and for ward-looking questions as these: What has been the effect of the huge CCC price-support programs on speculation? Reynold Dahl has been studying this question at the Univer sity of Minnesota. Then: What has been the effect of the CCC programs on grain prices? Have they stabilized grain prices? Have they stabilized them more than futures trading would have stabilized them in the absence of CCC pro grams? If the CCC programs were greatly reduced or aband oned in the future, would excessive storage capacity show up? If so, where, and what would need to be done about it? We have been investigating this question at Ames. And could futures speculation pick up the load if the CCC got out of the picture? Would a great increase in hedging and specula tion be required? Or is more and more of our feed grain supply going to be fed close to home, as Fred Maywald be lieves, so that less of it will enter commercial channels and less trading in cash and futures will be required? The great importance of the answers to these questions to the Board of Trade and other grain agencies is obvious; these are some of the really big questions that need to be explored.

Effects of Futures Trading on Prices Discussion MILNER: Time is running down and I am quite sure that you would like to have a chance to ask as many questions as possible. And so, with a good leader and three very good dis cussants, I assume that you may want to question any of the four. Professors Dahl and Shepherd, will you take these chairs and be in position to be asked questions as well as Tom. Who has the first question? GRAY: This isn't a question; I just want to welcome Tom to the club. (Laughter) And tell Allen Paul it is not too late to get out of town. (Laughter) MILNER: By consent we had arranged that we would not have rebuttals; but Tom has very properly asked for 30 seconds. HIERONYMUS: I would hate to pretend that I could re but all that has been said in 30 seconds; but two things occur to me that I would comment on. One. I think that between Mr. Withrow and myself there is a problem of understanding exactly what we were talking about in that area of price. I do not think there is other disagreement. And a lot of Mr. Dahl's criticism hangs on how he is de fining inventory. We have some difference in definition, but I think there is no real difference in thought. The thing that the remaining 20 seconds is for is a matter of the term significance. And no respectable statistician will claim me in the fraternity — because I do very cavalier things; but I simply say that the tests Mr. Shepherd referred to are tests of statistical significance. "Significance" is very dif ferent in what it means in the ordinary usage of the English language and in tests of statistical significance in which we [192] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES rule out items on the basis of extraordinarily rigorous stand ards. Now, I am a short odds player myself. You don't have to give me 20 to 1 before you get me to bet on a point. And I should say that to take the very arbitrary levels of significance the statistical fraternity uses and say that something is of no value because it doesn't meet those particular standards, im presses me only very negligibly. SHEPHERD: Insignificantly. HIERONYMUS: Yes. (Laughter) BLACK: I just want to remark that the rigors of the qualita tive analysis that goes along with it needs to be taken into account — is it reasonable in a real rigorous qualitative analysis. Now, on these examples of correlation that you mentioned, like the size of the feet and the age. You must take qualitative considerations into account as well as quantitative statistical tests. SHEPHERD: Yes. Mr. Black is well-qualified to raise a question with me since he was my major professor at Harvard. GOLD: Tom, I'm not in the mood for attacking it. I think this is something we ought to take up once and for all, though. I think it is time we stopped excusing the price manipulation that is taking place in the futures market. I think it is time we stopped trying to find excuses for them by saying that if we go into the economics departments we can find reasons for them. At any moment and time we can find reasons for either a bullish or bearish result after it has taken place. The fact remains that we have had price manipulation in wheat, we have had it in onions and potatoes. And the fact that the [193] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR exchange invariably takes the position of opposing investi gators instead of trying to beat them to it, I think, is going to help destroy any public acceptance in the futures market. Now, the fact is we want speculators in there. They in variably get beaten as the statistics would indicate. Let's at least try to give them a fairer shake by trying to avoid the manipulative aspect when they become dominant. I think that it is no secret that an attempt at manipulation in the wheat spread was known weeks before any official cognizance was taken. I think that the exchange should have been the one to start taking action first. I think we cannot continuously say this doesn't exist be cause the public knows it exists. And just as Mr. Bakken said, the courts were behind the public. In certain aspects I think the professors are behind the public in trying to shield what is to me a major shortcoming that must be overcome. HIERONYMUS: I'm not sure what really the question is. I can construe it this way; Why do I labor so hard to excuse manipulation? Now, with regarding the May wheat thing this past May, I don't want to make any categorical statement because I would like to look at the details and eliminate the possibilities. But I said that the manipulation of futures is illegal; in the cash market manipulation is perfectly legal. I took the posi tion that futures manipulation doesn't exist as often as is thought, if it exists at all. Further you have a devil of a time finding a provable instance of manipulation in the modern history of futures trading, nay, history. There is one time in the history of onions. And, interestingly, I suspect there was a collusionary activity that could be construed as manipu lative; and darned if it wasn't a manipulation in the opposite direction than people thought it was, and it failed.

Just off hand, I don't think there was manipulation in May wheat. And I think one of the reasons I doubt it is I estimated the outcome correctly. WITHROW: Your point is that why are your excuses be ing made, et cetera. I think as you look into the situation that every effort is being made by the exchange and by the C.E.A. to prevent manipulative practices at all times. And if you don't think that they are looking for these things — I write a market letter two or three times a day, or at least twice a day; and many times I have made very inno cent remarks which I felt had no influence at all, or were just simply calling the shots as I saw them; and I would get a call from the C.E.A. I was very strongly impressed by the fact that there was somebody looking over everyone's shoulder, not just mine, to see that these things didn't occur. Now, they have occurred in the past, nobody will argue with you there. But I think that there are strong organiza tions — strong within the exchanges, within the C.E.A. — to try to prevent them from happening. But just one other thought on this big May wheat deal back in, well, early spring. I happened to see some of the market letters that were written by the customers' man, of a firm which was very prominent on the long side. And I read these letters way back in early January when the market ac tually at that time was low relative to its high and low. In other words, there was no excitement, there was no enthusiasm, there was nobody looking over anybody's should er, there was no threatened squeeze. Well, so help me, they were the most provocative, most enticing, most alluring let ters that you can ever imagine. At that time, some of us dis- [195] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR cussed the letters over lunch. There were many people that felt the guy was absolutely right and they were wholehearted ly on that side. And there were many who took a different view. What I am trying to say is that the result of small group's opinion, strong opinion, that such and such a market action was going to take place and a lot of advertising of that fact drew innocent people into a situation which I don't think was manipulated to an extent that was claimed. GOLD: Well, the investigations and law suits that have come up in Kansas City are going to determine that. But wasn't it true that, not the general market letter writ ers but the actions of one man dominating a group which controlled perhaps twenty million bushels — which I as sume was far above the limits that were supposedly set — might be one of the things that could come out of this pres ent thing. WITHROW: I'm not trying to defend or castigate in any way in this case. GOLD: Why did the exchange let it go that far? WITHROW: It is a free country. And as I say, the previous year the speculator who didn't know anything about wheat who read a similar letter like that would have made a lot of money, and nobody's fingers burned much. This time we saw the other side of the coin and some speculators were hurt and so they complained, etc. Now, that is as far as I know about the situation. Whether they, the investigators, proved that there was fraud, etc. I don't know; and I don't think you do at this time. As I have said there is a police force that is working all the time to prevent this thing, and I think doing a fine job. FLOOR: I would just like to suggest that if you use Mr. [196] ©1960 Mimir Publishers, Inc. EFFECT OF FUTURES TRADING ON PRICES

Gold's thinking on the market we would probably close them much faster. FLOOR: On the contrary. FLOOR: Just a moment. Who would be the judge and jury to draw the line, where it is and so on? I think we have enough restrictions on these particular futures as they exist. FLOOR: We were talking about price variation; now, isn't price variation attractive to speculators and where do you draw the line as to what is not? MILNER: Several have talked on that. Whom did you want to address it to? FLOOR: It doesn't make any difference. Maybe someone else could put me straight on this. BLACK: We condemn certain people in the government and so on for inserting instability in the market, but almost in the same breath we don't want too much instability or variation. HIERONYMUS: I think that we would need to take 10 or 15 minutes to straighten this out but to put it briefly: I think the objective, the price objective, is to get the maxi mum possible stability in the market. Now, this doesn't mean there is not variability; but what a speculative market tries to do is to foresee everything that will influence price and discount all of those influences into the current price so that you come out with precise stability. This is the ob jective. BLACK: If you do that, you will still have quite a lot of variability because of outside circumstances. HIERONYMUS: That's right. We don't expect a perfect job out of it, with a perfect discounting market, with per fect foresight; if there were, then there would be perfect stability. This is beyond any reasonable hope of accomplish ment. But insofar as the market is able to foresee forthcom-

[197] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR ing events and discount the influence of those events into current prices, then it has a stabilizing influence. That is, yesterday, the market was discounting the in fluence of such change as there would be in the government crop estimates into yesterday's price. And insofar as it was doing two things accurately: one, accurately estimating what those estimates would be; and secondly, accurately estimat ing what the influence of those estimates on price, would be, it was stabilizing the price between yesterday and today. And in the one estimate, there was rather substantial change. In the other estimate, the one that the most concern was about, there was not much change. And the price variation of both of them a while ago, at 10:30, was not great; so it had been pretty well discounted. Now, the market did a very bad job of discounting the August 1st crop estimates; and, as Dick pointed out, all hell broke loose the next day. The average of the estimates of the August 1st soybean estimate on this floor was 511 million bushels. They missed it and the price adjustment the next day was large. Futures trading has a stabilizing influence and this is a desirable thing; I think it is. BLACK: You are using this term stabilization in two dif ferent senses; or at least, we are here. If you have a very jumpy year because of the weather and business conditions, you are going to have an unstable mar ket. If you will have a very normal sort of year, you will have a more stable market. Now, that is one thing, but to get a good fit all the time, every day, to what the market conditions are, you call that producing stability. Well, now, that is two different ways of using the word "stability," isn't it? I wonder if we don't need some other kind of word to

EFFECT OF FUTURES TRADING ON PRICES

describe this perfect fit. HIERONYMUS: I think we are falling into trouble be cause we are hedging. I think the first criterion is to have a price that fluctuates freely in response to changes in eco nomic forces; the fluctuation necessary to accomplish the adjustments necessary to changing conditions; this amount of price variation you must have. More price variation than that is undesirable price variation. BLACK: I think we are going to have to invent some word to prevent that confusion. You talk about monthly prices being more stable than between months. Well, aren't you going to expect that; you come out with your crop re ports once a month. Now, that is a change. As they change from month to month you are going to expect them to keep within a certain range within that month. HIERONYMUS: No. No, because the crop report is only one of the things that goes on. Estimates of the next crop estimate are continually made. In some months you will expect more variation than others because there will be more variation in natural factors. DAHL: I just want to make one point in connection with that question. I think it is very apparent that the loan pro gram associated with some commodities like wheat and corn has acted as a detriment to speculation because of its effect on price. On the other hand, most of the comments in this paper were devoted to onions. Now, here we have a commodity that has typically violent price fluctuations; and futures trading has been accused of increasing these rather violent price fluctuations. And I believe the point that has not been made clear here is that we have attempted to do some re search to see what the influence of futures' trading has been on price.

BROOKS: Along these lines, what is attractive to a specu lator? Is it a market that has considerable fluctuation or lit tle fluctuation? What makes a market attractive to a specu lator? WITHROW: We do a considerable business being a com mission house, with speculators, and I can tell you that they want a market that has a fluctuation but they don't want just wild, willy-nilly fluctuations. Speculation, as I recall, is a Greek word which means to foresee. They want to have the opportunity to foresee, to forecast something that is reasonable. Not just a flip of a coin, but something they can use some judgement on. And they do want a good amplitude of variation; I think that is true. Just one other point: I think nothing is wrong with varia tion, if it is in response to economically important factors. And, here is a good example: The cost of housing in this country has gone up, what, two or three times in the last 20 years. Now, there is a very violent up-fluctuation; and yet we have recognized our housing shortage because the price has been allowed to go to the point where contractors with profit motive have built homes and we have solved our problem. And I think there are other countries where they have rent controls and restrictions. France is one of them; where they are 10 or 15 years behind us because they didn't have a price fluctuation that gave this motivation to building and licked a real economic problem. GRAY: May I make a comment on Brooks' question? It will be short. The question of the extent to which prices fluctuate isn't [200] ©1960 Mimir Publishers, Inc.

EFFECT OF FUTURES TRADING ON PRICES the only matter concerning the speculators. If you look across from commodity to commodity you will find the ex changes have done not too bad on the level of spreads. In a sense it is fair to say that among commodities, from the viewpoint of a speculator who is trading on margins, all prices have about the same amount of margin. More work needs to be done in this regard, especially between the spreads and trade by itself. MILNER: I wish we could continue this. I know you are deeply interested and wish to go ahead for a while, as you have been in the two previous sessions; but out of fairness to the session this afternoon, we must quit now.

Part 4

THE FUTURE OF FUTURES TRADING IN OUR CHANGING AGRICULTURE

Allen B. Paul and William T. Wesson*

Introduction

T\h e present assignment is "to set forth the probable structure of agriculture and agribusi ness firms and, as a consequence, their needs for the func tions traditionally provided by futures markets." This di rective is clear enough. But in order to fulfill it, we must make two kinds of choices. First, what structural changes should be considered? Developments that have been men tioned include vertical integration and contract farming; horizontal integration, product integration, diversification and specialization among processing and distributing firms; public policies directed at economic growth, stability and farm incomes; and the nature of technological change in agriculture and in other economic sectors. Assuredly, one must consider all these, and more, for a comprehensive analy-

* Presented before the Chicago Board of Trade Seminar, Sept. 11, 1959. The views expressed in this paper are those of the authors and they do not neces sarily reflect the views of the United States Department of Agriculture or any of its other personnel. The authors benefited from a critical reading of the manuscript by John M. Brewster, Paul H. Cootner, and Harold B. Rowe. [203] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR sis. But this is not a manageable task. Instead, we choose to evaluate only the conditions that are most relevant for in terpreting the future of futures trading. The second choice is this: shall "the functions traditionally provided by futures markets" be taken to mean what tradi tional thought says they mean? The classical explanation of futures trading centers on price risks, the desire to shift these risks, and the potentials for doing so through futures trad ing. It would lead us to appraise the future prospects for price uncertainty, the changing incentives for shifting risk, and interest of different individuals in risk assumption. These are interesting questions, but they are not the ones we choose to examine.4' Professor Emery provided the classic exposition in 1896 in his book entitled Speculation on the Stock and Produce Exchanges of the United States. Twenty years later he wrote that "the proposition that organized futures trading (in those articles which naturally permit of it) increases the efficiency of marketing is a proposition more easily proved than almost any other practical proposition in the whole field of econom ics. It can be shown historically, statistically, theoretically, and practically."48 More than 40 years have elapsed since

7 Our formulation of futures trading recognizes that risk and uncertainty under - ly decisions to buy or sell commodity futures. However, we assign no unique role to futures trading in this respect. Rather, it is assumed that futures are bought and sold, the same as other assets, in expectation that positive yields will be realized. In this formulation, the meaning of risk to the individual can be understood only by examining the effect of transactions in futures on its total asset-liability position rather than by examining the futures transaction in isolation. For elaboration of the present concept see, Markowitz, Harry, "Portfolio Selection", Journal of Finance, Vol. VII, No. 1, March, 1952. Makower, H. and Marschak, J., "Assets, Prices, and Monetary Theory", Economica, N. S., Vol. 5, p. 261 (August 1938). Working, Holbrook, "Hedging Reconsidered", Journal of Farm Economics, Vol XXXV, November, 1953, No. 4. 8 Henry C Emery, "The Economic Bearing of Futures Trading in Agricultural Commodities," Proceedings of the Second Pan American Scientific Congress. Vol. 3, 1916, p. 22. [204] ©1960 Mimir Publishers, Inc.

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Emery made this observation. One wonders, if he is correct, why the proof must be made so often? It could be that the method of analysis still leaves something to be desired and that the issues need to be conceived in a more vital way. After some years of study at the Brookings Institution, we have come to believe in the merit of an alternative explana tion of futures trading which shall be used here.48 The idea is that futures trading is one of the many financial institu tions of a well-developed exchange economy. It facilitates investment of capital in growing, transport, processing, stor ing and distributing commodities. But it is not a financial institution in the sense in which money is received from one person and loaned to another, like the intermediation of lending by banks and insurance companies. Rather, the role of organized futures trading is to facilitate equity invest ment in commodities. In this role, futures trading is no different from any other dealings in firm contracts for forward delivery, which prac tice is widespread. Any forward commitment, however en tered, results in a genuine investment of capital in commodi ties even though no funds were to pass directly from the for ward buyer into the commodity business. The flow of funds, in consequence of such equity investments, is indirect under the more highly organized arrangements. The results of forward trading are the tendencies to increase the division of enterprise, the specialization in production and the co ordination of production with demands. Whether futures trading will rise or fall alongside other means for organizing economic activity depends on how the emerging conditions

49 The Brookings study (unpublished) made under the leadership of Harold B. Rowe, re-examines the economics of futures trading in agricultural com modities. Financial support for this project was made jointly by the Merrill Foundation for the Advancement of Financial Knowledge and by the United States Department of Agriculture. [205] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR of the market affect each. The organization of our paper is largely dictated by the choices we have made. In the first section the financial na ture of futures trading will be elaborated. Yet, we do recog nize that even here we cannot do justice to the central ideas and have some misgivings. The second section outlines rele vant tendencies in market organization, i.e. those concerning the nature of the operating units, specialization of produc tion, capital needs and sources, and enterprise division. The third section examines these tendencies in terms of the future of futures trading. This entails a projection of futures trad ing activity tested against certain structural developments, namely, multi-product lines, contract farming, vertical inte gration, and technology and related matters. In a final sec tion, some closing observations are made. The Nature of Futures Trading In our view, futures trading is one out of the many finan cial institutions of a well-developed exchange economy. The meaning of a financial institution is derived from the meaning of a financial system. To quote Professor Boulding: The principal function of the financial system is to separate the ownership of real capital from its control, that is, to enable people to administer real capital with out owning it, and to own it without administering it . . . The tangle of financial relationships and financial assets that lie between real capital and its correspondent net worth (ownership) has the effect of organizing real capital into complexes under unitary control which do not correspond with the complexes of ownership. If there were no financial system, no system of debt, credit, and securities, no financial assets and liabilities, then every balance sheet would consist simply of real assets on one side and net worth on the other; every person

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would have to administer the real assets which he owned, no matter how incapable he might be at such a task.60 As suggested by Boulding, such results are achieved by an exchange of financial claims. Broadly speaking, these in clude: (a) fixed money claims such as cash, notes, bonds, charge accounts, mortgages, and rent obligations, (b) fixed commodity or service claims such as bills of lading, ware house receipts, leases, and contracts for deferred delivery, (c) residual claims such as partnership agreements, corporate shares, and the like. Those who provide the financial means may do so on a great variety of terms in which different de grees of safety and yield may be agreed to. The social benefit of a financial system is that it enables resources to be used more productively. Each and every scarce resource is owned by someone and he who would use it must command it. If such command is not obtained, the operator is limited by the resources he himself owns. This indeed would mean small-scale production, limited techno logical means, and fewer goods and services. The evolution of the financial system and the evolution of specialization in production are interdependent. Both are still evolving. While all this is clear, there seems to be some difficulty in accepting futures trading as an integral part of the financial system. The usual view is that futures trading merely aids the banker to finance the hedger. The bank is held to be the valid financial institution and futures trading merely facili tates it in performing its function. Such doctrine is not satisfactory mainly because it rele gates the speculator (more aptly called the speculative in terest) to an ancillary role in the marketing system. On the contrary, the speculator is an important financier. By com mitting his assets to commodity futures he strongly influences

60 Kenneth E. Boulding, A Reconstruction of Economics, p. 276. [207] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR the cost of carrying. The speculator's role is no different whether he buys the actual commodity and stores or hires custom storage for it, or whether he buys contracts for de ferred delivery of the commodity which in effect obliges him to pay someone else to carry the stocks. Of course, hedgers do make individual stock-carrying decisions. But, in the aggre gate, these decisions mainly influence how, where, and with what economy stocks are carried and do not appreciably influ ence the total amount of stocks held.51 There propositions are not new but they are so easily overlooked or misunderstood that even the most learned students of markets sometimes draw wrong conclusions on who bears the cost of holding and who influences the rate that stocks are released into consumption.62 In support of the view that the speculator bears the cost of carrying stocks, we can do no better than to quote testimony given by Mr. Will Clayton some three decades ago.63 Q. About how much did it cost you to keep the average amount of cotton you had in New York? A. It cost us nothing . . . because we bid in the near month and sell in the distant month, which is approximately equal to the cost of carrying the cotton so that the cost

51 Strictly speaking, the hedger influences the amount of stocks carried forward indirectly by varying the amount of storage services he supplies at a given price of storage. However, in practice these variations are quite small com pared with the variations in the demands for storage services. In all our discussions, we use the words "hedger" and "speculator" in the usual polar sense. This is expository technique only and it is not to be confused with the actual world in which the two are often not clearly distinguishable. 63 For example, R. G. Hawtrey has said: "In the case of seasonal products the carrying of stocks is an onerous function and the merchant who performs it gets payment in the form of a premium of futures over spot prices. Even in the case of non-seasonal products such as minerals, the merchant who sells forward to a manu facturer relieves the latter of the cost of holding stocks." (Italics supplied) "Theory of the Forward Market," The Review of Economic Studies, June 1940, pp. 204-205. 53 Cotton Prices, Hearings before a subcommittee of the committee on Agricul ture and Forestry, United States Senate, Seventeenth Congress, First Session, April 3, 1929. pp. 588-589. [208] ©1960 Mimir Publishers, Inc.

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of carrying it was thrown on the speculator, where it belonged. Q. Let us figure the amount of expense you paid out. About how much a month did it cost you to keep the cotton there? A. It didn't cost me anything. Q. What is the expense? A. The expense is approximately, as I said, 75 cents per month per bale .... Q. Then if you had 100,000 bales, it would cost you ap proximately $75,000 to $100,000 a month to carry that cotton? A. $75,000 a month for carrying 100,000 bales, is correct, but it did not cost Anderson, Clayton & Co. that. Q. It cost somebody that. A. Yes, somebody has to carry the surplus crop. Q. In the first instance you bore the expense, did you not? A. We pay it out of our own funds to New York, exactly as we pay it out of our own funds when we sell the cotton in Liverpool or to a Lancashire spinner and deliver it to him in his country. Q. Now, you bore all of this expense to New York, and you paid that expense, plus the carrying of this cotton, and it has been there about a year; how much total ex pense has it cost you or have you paid out to keep this cotton in New York? A. We have not paid out anything. At another point in the testimony, Clayton showed that the speculator is dependent on specialized services provided by others to carry out his enterprise of carrying stocks. The providing of such services is the economic role of the hedger.6*

I knew of one concern that was very rich that thought cotton was selling very low, and they wanted to invest in it. The exchanges were closed. They bought 30,000 bales of cotton and put it in storage in Memphis, Tenn., and held it for a year or two and then sold it at a profit. But they had to arrange for somebody to buy that cotton for them, in the South; they had to have somebody who knew how to class cotton, and how to weigh cotton, who would come into the situation to act as agents and brok ers. They had to have somebody to store it for them. And when they wanted to sell it they had to employ the same technique ... In that instance this particular party got his interest in cotton. He bought the 30,000 bales. But there were thousands of other people throughout the world who wanted to take an interest in cotton, but were unable to do so because they were far removed from the cotton situation. They needed someone who could buy it; someone who could . . . (arrange loans for it) and who could handle the physical cotton. Therefore, they were unable to take part and invest in cotton. It is this distinction between speculator and hedger which we shall emphasize — the distinction between carrying stocks through time and providing the services required to carry them and not the distinction between degrees of risk as sumed by each party. What is the role of the man who is responsible for hold ing stocks over time? Professor Lerner has given a clear statement: A man who does not consider himself to have any in fluence on the market price but who believes that the price is going to rise or is going to fall quite independ ently of his own actions, and who buys or sells in an at tempt to make a profit, is a simple or productive specula- [210] ©1960 Mimir Publishers, Inc.

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tor. We may call such an individual a speculator with a small "s." He takes a single product available at one time and turns it into a single product available at an other time. We have seen that this is to be considered as the production of one good out of another . . . .K Having labeled the speculator a true producer, Lerner sug gests why such activity may be socially useful: All perfectly competitive speculation is in the social interest whether the optimum division of each factor between its different products is reached or not. Every speculator who buys cheap and sells dear improves the allocation of resources between the different prod ucts. He provides the rest of society with something that is valued more highly in place of something that is valued less highly .... Even if the speculator should be mistaken and make a loss on his deal, the other members of society will still gain unless some of his loss is imposed on others by his bankruptcy or default . . . .6° Then, Lerner shows where the short-seller fits: Competitive speculation is socially useful even when the speculator makes a profit out of undertaking to sell things that he does not possess, however much that may savor of unholy magic or even downright trickery. For the speculator is then, in effect, indirectly shifting goods from a future use to a present (or less remote future) use, and he makes his profit out of the social benefit that comes from persuading people to consume more now rather than leave goods until next year when they will not be needed as urgently as they are needed now. The

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speculator, by offering to sell at a lower price for de livery next year, lowers next year's expected price. This discourages those who have the good from storing it until next year so they put it on the market, lower the price this year, and encourage consumption now. If the speculator is right he makes a profit which comes out of the social gain, leaving some gain for others. (But if there are enough speculators to equalize the price, they make no profit — all the gain goes to the public.) If the speculator is wrong he bears the whole of social loss (if he is rich enough) and pays an additional fine to the consumer . . . . 67 Finally, Lerner observes that popular hostility to speculators is due to two things; namely failure to distinguish competi tive speculation from monopolistic or aggressive speculation wherein powerful interests can extract tribute from the pro ductive members of society and do so even while they dimin ish the total product and, to "the shifting of blame from those who are responsible for the extremes of an uneconomic state of affairs to those who benefit while actually engaged in remedying them."38 Who are these beneficial speculators? Professor Lerner's work is directed at other objectives than describing the insti tutional arrangements through which speculators work. But his examples show a broad conception. At one point he refers to severe punishment meted out in Russia to "those who in times of famine and for personal gain carried food from places where it was not so scarce to others where people were starving." Apparently these were the traveling mer chants who took title to goods and themselves transported it. At another point he points out that the usefulness of specula-

THE FUTURE OF FUTURES TRADING tion "goes ill with the hostility which people who have to work hard for their living often develop against the mysteri ous gains that speculators make in offices while dealing in goods which they could not even recognize."59 This could be the modern day speculator in futures. His short-seller un doubtedly is a futures trader, although there are other ways of selling short.

While the techniques for speculation have, indeed, changed over time, it would be wrong to assume the speculation in commodities is essentially confined to organized futures trad ing.™ A futures speculator is but one of a variety of open

59 See footnote 10. "° Professor A. P. Usher has shown the changing techniques in his interesting article of "The Technique of Mediaeval and Modern Produce Markets," Journal of Political Economy, 1915. Under the prevailing conditions of trade, changes in value in a period of time could not be separated from the differences in value in different markets. The purchase and sale in distant markets were not simultaneous . The changes in the technique of market organization in the eighteenth and nine teenth centuries have made it possible to distinguish sharply between the truly speculative time transactions and the essentially non-speculative transac tions between different places. In the Middle Ages, the speculator in produce was practically limited in his operations by the amount of his personal wealth. Today, goods held for speculation are largely carried on credit. In abstract terms, the difference may seem slight, but in reality it involves a complete transformation of the technique of trade, and the reorganization which today makes possible the extension of credit in this field also brought to an end the confusion between the speculative and nonspeculative elements of dealing in produce, pp. 365 367. Professor Usher develops other interesting ideas in the article but he paints with too strong a brush in holding to polar concepts of speculation versus hedging. For example in point is the assertion that "When the manufacturer of middleman hedges . . . He avoids all risks of gain or loss by reason of changes in the price of the raw material in order to confine his attention to the technical problems of the process of manufacture or sales." (pp. 381.) (Italics supplied.) [213] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR interests, i.e., those who hold claims to commodities with out offsets. The open interests are simply those whose net worths are appreciably affected by changes in the value of spe cific goods (growers, assemblers, merchants, and processors as well as the general public and governments.) It would be less confusing for purposes of analysis to avoid where we can the word "speculator" since it tends to create an image of a class of people who somehow perform a unique economic function. In order for someone to assume an open interest in com modities, he needs to acquire the necessary claims. The ex change of assets involved in acquiring such claims denotes investment of capital in carrying stocks. This seems clear enough where titles to goods are purchased. But in the case of commodities bought for deferred delivery, there is much resistance to this interpretation. Forward contracts are widely held to be paper commitments only, since no money passes and nothing seems to happen. In a modern financial system there is no need for the fu tures buyer to provide funds to the hedger with which to purchase commodities. The flow of funds into investment is roundabout and, in practice, it is evidenced largely by bookkeeping transactions." Suppose contrary to fact the futures buyer did advance all the funds to the seller on enter ing the contract instead of merely depositing security, as now. This advance would constitute in effect a money loan, as

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Professor Hicks has shown.62 Hence the futures buyer would assume the dual role of lender and enterpriser.68 He, in turn, would borrow from his bank by pledging this prepaid claim as collateral. The bank might adjust periodically the amount of the loan to the current price for the commodity (assum ing a reasonably competitive market for the commodity.) At any time, it could sell the contract to protect its position if the borrower failed to make restitution. Thus, the only funds put up by the futures buyer would be limited to security re quirements (as under the present system), because the lender is secure in knowing that he can turn the collateral into a predictable amount of money. Of course, it would be an awkward way of providing loan funds. Banks would have to service many small loans (to buyers of futures) instead of a few large loans (to hedgers). The present scheme of things does all that needs to be done. It gives the banker assurance that futures buyers will stand by their enterprise commitments on which the safety of the banker's loans to hedgers depends. In some cases the hedger may not immediately increase his borrowing. He may not borrow altogether. Here the hedger starts with cash sufficient to buy commodities and then gives up cash to pay for them. But by hedging his position, his credit becomes enhanced. Professor Hart has observed that credit and cash are close substitutes in the conduct of busi ness in a modern financial system: In business, being able to borrow contributes to "li quidity" — even though we lack statistics on it — is it self a substitute for having cash on hand, as a safeguard against emergencies, and gives the potential borrower

FUTURES TRADING SEMINAR more freedom of action.64 Freedom of action is valuable in the conduct of almost any business. For example, a farmer who sells his growing crop for deferred delivery thereby im proves his borrowing capacity which would enable him to seize upon some business opportunity. Perhaps the greatest difficulty in accepting this financial interpretation of the role of futures trading may be traced to divergent concepts of ownership, capital and credit. Owner ship in its broad sense means a right to use or dispose of prop erty or its yields. While a title-holder ofttimes is held to be "the owner", his rights are in fact circumscribed by the rights others may have in his property. They too are the owners in an economic sense. Such ownership is widely dispersed by the complex layering of financial claims in modern capitalism. While debt claims are now taken for granted as a valuable property, Professor Commons tells us that "it required the entire Seventeenth Century for lawyers to complete the in vention of the negotiability of debts" and that it also required "all of the centuries following to invent ways of making this kind of promise negotiable."65

The purchase and sale of commodity futures means an exchange of a money debt claim for a commodity debt claim. Both promises to pay are property in the modern meaning of the word. The saleability of debt is based on the expecta tion that the other party will fulfill his promise — that is, it is based on the credit of that party. Put another way, credit is the market's estimate of a person's ability to satisfy his debts. Credit has a value and it should be regarded as an

*A. G. Hart, Money, Debt, and Economic Activity, 1948, pp. 75. 5 Institutional Economics, pp. 392-393. A summary of various aspects of owner ship is provided by L. D. Howell and C W. Bucy, "Rights and Duties of Ownership", Marketing, op. cit., p. 297. [216] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING integral part of a person's capital. While accounting con ventions do not provide for its entry as an asset in the balance sheets, it is treated by many lenders as if it were so entered. The lawyer — economist MacLeod wrote over 100 years ago that: If it were asked what discovery has most deeply affected the fortunes of the human race, it might probably be said with truth — The discovery that Debt is a Saleable Commodity . . . ." If MacLeod's word "Commodity" were changed either to "property" or "asset" it accurately conveys the present con cept of credit. The capital of society, in real terms, is the stock of re sources having value that, together with free resources, is organized into a certain productive capacity. In terms of ownership, a consistent definition of capital is the net worth of all members of society — the sum of the assets minus the sum of the liabilities. A futures contract is one of the asset- liability entries. It denotes a dual creation of debt — the party that issues the commodity claim against itself draws down his credit in exchange for a money claim against the opposite party; the party that issues the money claim against itself draws down its credit in exchange for a commodity claim against the other party. This mutual exchange of debt claims does not in itself change the net worth of either party. The changes come afterward.8' Finally, an objection to the present financial interpretation of futures trading may be raised on the grounds that the mag nitude of lending based on futures trading seems relatively small. One might think that the amount that hedging in-

FUTURES TRADING SEMINAR creases the hedger's borrowing power measures the financial contribution of futures trading. However, this does not show the full significance of it without further interpretation. The ratio of the amount loaned to the market value of an unhedged commodity could be quite high, say 9:10, provided the lender feels he can always sell warehouse receipts (or other collateral held by him) at a price high enough to cover the loan. Thus, the amount by which the ratio of loan to commodity value is increased by hedging is a function of the marketability of the collateral and the level of its price. But, in loaning against hedged commodities, the bank receives added assurance that the loan will be repaid and the hedger receives assurance that he can carry through his commodity plans irrespective of actions taken elsewhere in the financial system to protect this loan. This assurance to both banker and hedger is provided by buyers of futures. For these reas ons, the bearing of investment by speculators on a given course of commodity production cannot be assessed by look ing only at the relation between hedging and the size of loans. Rather, it is necessary to identify and, wherever pos sible, to trace out the several economic consequences. The economic significance of increasing the amount of the loan through hedging appears more telling when viewed in relation to enterprise division and scale of production. For example, a step-up in the ratio of loan to collateral value from 6:10 to 9:10 is an increase of 50 percent. But, the sig nificance of this increase for the organization of economic ac tivity is that the scale of operations of a firm with a fixed amount of capital of its own could be four times as large as otherwise. Thus, a firm with $100,000 of its own capital could have one million dollars at its disposal if it hedges as compares to but two hundred and fifty thousand dollars if it does not hedge.

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Finally, the importance of enterprise-sharing, should be interpreted in terms of the firm's entire production plan. Sup pose farmers producing a given crop were to borrow, in the aggregate, only 10 percent of their seasonal capital require ments on the basis of forward sales of their expected crop. This fact alone would not measure the importance of these loans. Lending practice requires hedging only that part of the expected crop that would be sufficient to assure payment for the advance of operating capital — ranging say, from one-fourth to one-half the value of the crop, depending on the commodity and local circumstances. Thus, from 20 to 40 percent of the crop production and not merely 10 percent would be involved. Loans to these farmers promote the or ganization of production in larger farms at lower unit costs than otherwise might be the case.68 No one can say for cer tain how much less financing these farmers might obtain, if it were not for hedging their crop, and on what terms the fi nancing would be made available. But it must be remem bered that at the margin of adjustment a little cash or credit may be the strategic factor in carrying forward on an entire plan of production. Professor Hart calls this "the principle of linkage of risks," wherein troubles come in bunches.69 As one moves forward from the grower to the next stages in the marketing channel, the amount of loans that historically has been predicated on hedging increases as stocks of com modities are put in commercial storage. The significance of such loans to the organization of the business of assembling, processing, transporting, storing, and merchandising is no different than for growers.

8 Some empirical data bearing on these ideas may be found in: William T. Wesson, The Economic Importance of Futures Trading in Potatoes, Marketing Research Report No. 241, Agricultural Marketing Service, Marketing Research Division, U. S. Department of Agriculture. 1957. 8 Hart, op. cit. pp. 198-199. [219] ©1960 Mimir Publishers, Inc.

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Having inquired into the role of the speculator, one now may ask what is the role of the hedger? Mr. George Wilkens looked on the matter from the individual's viewpoint in rec ent testimony when he said: If the milling companies did not have the hedging market available, the futures contract system in wheat, I am satisfied they would have to go into the money markets to get additional dollars to use to own the inventories which they need to operate.70 It is merely an extension of Mr. Wilkens' remarks to say that the amount and the terms under which these dollars would be forthcoming from the "money markets" might be considerably different. As a result, the miller might find it necessary to reorganize his business in some way. Reason ing from the individual to the group, there could well be an appreciable reorganization of productive operations in the marketing system for wheat. The line of analysis is a familiar one. Futures trading en ables merchants, millers, warehousemen and even farmers to specialize. Specialization of production implies realiza tion of economies of scale and the further application of tech nology. Where the present approach leads is not essentially different from work of others. The present approach states that the speculative decisions help determine the rate stocks move into consumption and that the hedging decisions help determine the amount of services offered to grow, transport, process and store these stocks. The quantities of services that hedgers will offer depends on the price received for them. The price of services is a spread between two commodity prices, and this spread is merely an alternative to an explicit fee. It may be either a positive price or a negative price.

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Both are competitive prices for rendering the same kind of service (unless regulated). Working's studies of the spot- futures spread as a market-determined price for providing specialized storage services is an important contribution to development of this type of market analysis." Also, the spot-futures spread may be regarded as a market- determined price for the command over current use of com modity stocks. It is the price anyone would have to pay for interim use of commodities in order to market his services in the transport, processing, storage, and merchandising there of. Here, then, emerges a conception of a price structure cor responding to the three dimensions of production, with the time dimension being integrally related to the form and place dimensions. The behavior of these prices and spreads and their interrelationships with production adjustments and re source use are neglected areas for research. The present approach further suggests evaluation of fu tures trading in the coordination of production with demand in the sense of achieving a better allocation of resources. Spot and futures prices are guides to production as usually noted. But the popular view of futures prices as forecasts of expected spot prices is highly questionable. Current pric es for both spot and futures deliveries reflect the same basic supply and demand forces, hence, the one is no better than the other as a forecast. But one point is easily over looked. Hedging actually discounts into current prices the projected outputs of the hedger. Since his outputs are priced in advance of completion, a lag is taken out of the system

71 See Holbrook Working, "Theory of Inverse Carrying Charges in Futures Markets" Journal of Farm Economics, Feb. 1948, and earlier articles by Working that are cited in his footnotes. In additon, other students have expressed ideas similar to the ones we have suggested here. For example, see Hardy and Lyon, "The Theory of Hedging," Journal of Political Economy, 31 pp. 276, 1923; John Burr Wil liams, "Speculation and the Carryover," Quarterly Journal of Economics, May 1336; and Lester G. Telser, "Futures Trading and the Storage of Cotton and Wheat," Journal of Political Economy, June 1958. [221] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR for adjustment. For example, as commitments are made to provide more services of one type, the competitive price for that service immediately tends to fall, suggesting to each po tential supplier what his profit will be from added investment. Except in the growing of certain crops, more or less contin uous adjustments of market services to changing prices are possible. This type of coordination is commonplace in business. One can think of many investments that would not have been made if it were not for advance orders, e.g. in production of magazines, buildings, machine tools as well as farm crops. It may be instructive to reflect on an economic system that evidently lacks such coordination. A recent article by a Russian writer had this to say: One of the primary causes of failure to fulfill the plan for launching the operation of industrial enterprises is the mistaken practice ... of dissipating capital invest ments among a large number of projects . . . The striv ing of organizations and enterprises to start new con struction under any and all circumstances, results in dissipation of funds among numerous production proj ects, an increase in periods required for construction to 3, 4 or more times as long as scheduled . . . the drag ging out of scheduled periods of construction is due, to a considerable degree, to failure to coordinate plans for capital construction with plans for supply of materials and equipment. The shortcomings in the very system of supply of materials and equipment further complicate the difficulties in prompt provision of materials and equipment to construction projects.72 If each of these laggard projects had been expressed at the 72 A Kachalov, "A Major Means of Increasing the Effectiveness of Capital Investments." USSR Monthly Journal Volprosy Ekonomiki (Problems of Eco nomics) May 1959, pp. 27-31. [222] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING time of inception in forward orders for the necessary materials and labor at firm prices, then each project would have been discounted when launched and consequently only that amount would have been launched that could reasonably be com pleted on schedule. Such a market system would virtually have insured this. Basic Tendencies in Market Organization In order to interpret the future of futures trading, it is necessary to examine certain basic tendencies in market organization. Accordingly, attention is now directed to some of the significant trends and adjustments in (1) the number and size of operating units, (2) specialization of production, (3) capital needs and sources, and (4) enterprise division. The following section will deal with these tendencies in terms of the future of futures trading. Numbers and size of operating units. — From 1939 to 1954, the number of farms, farm products assemblers, food process ing plants and retail food stores declined sharply. The output per operating establishment increased sharply. Divergent movements behind the averages cannot be dealt with here. The trends show that large-scale operations have developed throughout the commodity marketing system. They result from the interactions of various internal and external econ omies of scale under changing technology. But on further inspection, the data show a surprising fact. The number of independent wholesaling establishments, oth er than assemblers, has increased sharply. These are the merchants who buy and sell for their own accounts, as well as agents and brokers, dealing in raw farm products or in food products. The average output per establishment of this group increased relatively little from 1939 to 1954.'3 The turn- ,a Taking the Census counts of operating establishments in 1939, 1948, and 1954, adjusted for comparability in coverage in 1948 and various indexes of output for these establishments, the following set of data appear. [223] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR over of wholesaling firms seems to be relatively high. In dependent wholesaling is about twice as large as wholesaling by manufacturers and retailers. Whether, and to what ex tent, the former is being supplanted by the latter is hard to judge without more study.

Table VII

Percentage change from 1939 to 1954 Type of Number of Output per establishment establishments establishment1

Commercial farms - 27 + 70 Farm product assemblers - 38 + 140 Food manufacturing - 20 + 90 Food manufacturers sales branches - 2 + 58 Merchant wholesalers, raw farm + 132 - 6 Merchant wholesalers, food pdts. + 22 + 27 Agents and brokers, farm & food + 24 + 8 Retail food stores - 25 + 132

'Derived by dividing an index of output by an index of numbers of establish ments. The index of farm output is that of the United States Department of Agriculture. The index for food manufacturing is that of the Federal Reserve Board. The indexes for each of the trade sectors were constructed by adjust ing the Census of Business data on sales by appropriate price deflators. Thus, for the trade sectors, the output is merely an inference drawn from measures of the physical volume of materials "handled" in each sector. The inference is valid only to the extent that the services performed on each unit of volume did not change over the period. The correction of this defect must await further studies. This pattern of organization suggests a state of flux in the food and agricultural economy. Evidently there is an increasing demand for specialized wholesaling services but no great economies of scale that can be realized by organiz ing fewer and larger units to provide such services. Changes in products and in sources of supply, shifts in population and in their demands, and periodic rearrangements in types of outlets, modes of transport and methods of doing business unsettle the environment. Wholesalers may be specializing by type of customer outlet and lining up several deep behind given outlets. This could be a fairly efficient way of provid ing the food services needed to satisfy the demands of a fluid

[224] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING economy. Such conjectures are worthy of study.74 Specialization. — An operating unit may specialize either by limiting the number of products or by limiting the serv ices rendered per unit of product, or both. The two aspects are equally important in appraising the overall trend in specialization. But knowledge of the facts is still quite meag er. We do not know for sure whether food retailing has be come more specialized or less specialized over the years. While the individual stores tend to carry more items than formerly, there has been a long-term decline in the amount of service per item. On the other hand, shopping in more pleasant surroundings conceivably could be counted as an additional service. Most wholesalers of farm and food products have been spe cialized by product lines for many years. The decline of the general-line wholesale grocer has been accompanied by the rise of the modern warehouse serving a more or less cap tive group of stores. Perhaps fewer services per unit are now provided than formerly. On the other hand wholesalers catering to institutions may provide more service per unit; they have increased in numbers. On the whole, food processing plants have been special ized by product lines since early times. There is evidence of increasing specialization, but the total picture is unclear.'6 Whether recent increases in processing services per unit re flect primarily the output of existing establishments or of new specialized establishments is not certain. Knowledge about the tendencies in agriculture is more sat isfactory. The number of enterprises per farm has declined.

"See Willard F. Williams, "Structural Changes in the Meat Wholesaling In dustry," (Journal of Farm Economics), May 1958,, for interpretation of such developments in the meat industry. 76 See footnote 28. [225] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

The amount of farm inputs that are home produced rather than purchased also has declined.76 Together, these trends result in greater specialization in agriculture. Some of the more pronounced trends in crop and livestock production can be seen clearly while others, though pervasive, are not as apparent. In recent years, the latent possibilities for furth er specialization have seized the imagination of many people. Important experiments in crop and livestock production are underway. These are being watched with great interest. Sources of capital. A projection of the investment per farm in 1975 was recently put at $80,000, (1958 prices). This is double the 1954 figure." It will be beyond the means of the typical farm family unless the family is well favored by inheritance, or it gets high prices for many years, or it lives frugally. The weight of evidence points against such events. Probably the share of farm capital provided by out side sources will increase. It is unlikely that the corporate organization of farms would provide a solution. By and large, the corporation it self would attract little capital from outsiders other than from relatives and friends who might invest in any case. More likely, the outside capital will be secured by borrowing, leasing, joint-account production, and by forward sales of output, irrespective of the legal form of the farm business. Corporate organization is important in the food processing and in the food distributing industries. Since many of these businesses are most profitably operated with large-scale pro ducing units, the corporate form has been an appropriate method of raising large amounts of capital for use over an indefinite period. Yet it must also be said that the financial role of the corporation can be greatly overstated.

78 Kenneth L. Bachman, "Prospective Changes in the Structure of Farming," USDA, ARS, Nov. 1958. (Talk before the annual Outlook Conference.) 77 See footnote 30. [226] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING

True enough, corporations do about 90 percent of all fac tory processing of food but they do only 50 percent of the independent wholesaling and only 45 percent of food re tailing. Moreover, corporations have but 50 percent of the food processing plants. 30 percent of the food wholesaling plants and 10 percent of the food retailing stores. Consider ing that probably over one-half of the corporations in these sectors are nominal corporations — in the sense of not being able to raise capital from outsiders and for an indefinite period — it must be concluded that all but a relatively small number of firms, corporate and non-corporate, must rely on other means of raising capital than by issuing shares.78. The analysis does not alter the fact that corporate methods of raising capital are very significant in the organization of enterprise in the food economy. If one were to ignore large corporations in their financial relationships to their suppliers and to their customers, important methods of financing economic activity in commodity markets would be missed. Enterprise division. — Specialization of production is a physical phenomenon. To obtain lower unit costs through specialization, the scale of physical operations and therefore the amount of capital invested in the operation usually must be increased. How does the economic system arrange that one person operates the resources provided by others? The answer of course is through loans, leases, partnerships, syndi cates, corporations, forward trading and so on. Because of business uncertainties the capital is financed both as enter prise investments and as money loans.

78 There are various possible criteria for measuring nominal corporations. A conservative yardstick is assets in the balance sheet of the corporation of the same order of magnitude as assets in the balance sheet of the commercial farm. Basic data are given in Statistics of Income, Internal Revenue Service and in Census of Business and Census of Manufacturers. [227] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

Man has invented various ways of dividing up an enterprise investment without dividing up the physical operation it self. Some are equal-share arrangements, like partnerships and corporations, in which all enterprisers are in the same boat. All gain or lose according to the profitability of the entire venture. Others are unequal-share arrangements in which the profits of the separate shares are largely independent of one another. Under "contract farming" and forward trad ing, an enterprise becomes subdivided into different parts and these parts are separately transferred to different parties according to individual preferences. The nature of the differences between "contract farming" and forward buying and selling may be readily illustrated.'9 If a broiler producer is treated essentially as a laborer work ing for a fixed fee, with little responsibility or reward for the success of the enterprise, then there is a wide gulf be tween contract farming and forward trading. Economically speaking, the farmer might as well be employed as a wage earner in a broiler factory. At the other extreme, if the grower accepts full responsibility for the rate of gain and death losses then the difference is nominal. The broiler producing enterprise becomes subdivided into two parts just as house-building enterprises may be subdivided into two parts — as between the speculative builder and the contrac tor. The feed dealer assumes the responsibility for having so much resources converted into so much meat at a later date. The grower assumes the responsibility for converting these resources. This is exactly the subdivision of the broiler en terprise that might be achieved through forward buying and selling, but the mechanics would differ. For example, the

"For illustrations of the variety of arrangements in force see Contract Farming, USDA, Information Bulletin, No. 198, 1958. [228] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING grower could provide all the inputs and at the same time sell his expected output for deferred delivery at a fixed price. Thus his net return would be determined by his efficiency in turning inputs into outputs. No more capital might be need ed under one scheme than under the other and the scale of operations might be alike. Most "contract farming" agreements fall between the ex tremes just described. They are flexible arrangements for dividing up an enterprise and, therefore, are readily adapt able to a wide range of individual conditions. At the same time, there has been an extension of forward buying and selling under fixed terms in both crop and livestock enter prises, as in growing cotton and feeder cattle. This suggests a wide applicability of such enterprise sharing arrangements. The extension of either or both methods tends to be stimu lated by the increased use of operating capital in modern com mercial farming. Bearing of Structural Changes on Futures Trading The examination of the foregoing tendencies in terms of the future of futures trading will start from a reasoned projec tion of futures trading activity. The projection will then be tested against selected features of modern commodity market ing systems. The tests involve only general features, namely: Multi-product lines, contract farming, vertical integration, technology and related matters. No attempt is made to examine the great number of specific features applicable to futures trading in individual commodities. Trends and projection of futures trading. — Most of the history of organized futures trading — extending back to the Civil War period — cannot be neatly quantified. The trad ing was mostly in wheat and cotton, the two great export crops of the pre-World War I era. The peak of activity may have been reached even before the turn of the century. [229] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

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THE FUTURE OF FUTURES TRADING

It is possible to quantify futures trading over the past thirty years using the open contract data published by the Com modity Exchange Authority. Open contracts measure the contracts in force at the end of a trading day. In table VIII, there is shown the average of month-end open contracts for 24 commodities traded on U. S. commodity exchanges for the period July 1931 through June 1959. From these data we have constructed an overall index of futures trading using the average of futures prices in the 1951-55 period as weights.80 Similarly, separate indexes were constructed for four major categories of commodities, table IX. The main omission is futures trading in tropical and semi-tropical crops.

Table IX. — Index of Futures Trading Commitments in Agricultural Commodities 1931-35=100

Period "Edible 4Semi- (Year begin Total of 23 Animal "Export Perish- ning July) Commodities Teeds Products Staples able Crops 1931-1935 100 100 100 100 3 1936-1940 81 74 144 76 4 1941-1945 60 55 74 55 28 1946-1950 87 98 131 76 =100 1951-1955 121 141 147 86 344 1956-1958 100 122 179 57 314 1 Corn, oats, shorts, bran, middlings, grain sorghums, soybean meal, cotton seed meal. 2 Butter, eggs, and lard. " Cotton and wheat. * Potatoes and onions. s 1946-50 used as base period; futures trading in onions and potatoes was not important in earlier periods. The overall index has held up surprisingly well over the three decades considering the market conditions. Free market operations were substantially suspended during World War II, resulting in a large decline in activity during 1941-1945. Both before and after this period, price supports have been effective. The 20 point drop in the index since the 1951-55 period probably was mainly the result of price support oper-

80 In a few minor instances, other prices were used in lieu of futures prices. [231] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR ations in cotton and wheat. When the loan rate is announced, the CCC is committed to accept the responsibility to carry the commodity at that price. It potentially supplants the need for private assumption of the responsibility. Since price supports usually apply only to certain farm prices, rather than to all market prices, there sometimes is considerable room for competitive determinations; sometimes there is little or no room. The underlying strength of futures trading has been in feeds, animal products, and semi-perishable crops. The weak- Figure 7. Relative trends in futures trading by commodity groups, 1931-58: Individual indexes relative to overall index

Percent r i " i i i II (1931-1935=100) 200 - -

180 Edible / /\ f animal / / \j/ products / 160 / \ /

mo -—f *T /- v / " . x ' \ / 120 - / "*' ••'

100 ^""~~r-^^_ ^^—— J""" T'eeds ,^j2£^=c^r-f.r 80 ^^^ 60 Export —J 10 staples

20 0 ? I i i i I i i 1931- 1936- 19a- 19/46- 1951- 1956- 1935 191*0 191*5 1950 1955 1958 Based on data in table IE. The straight-line trend for each series was fitted by inspection. [232] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING ness has been in the great export staples, cotton, and wheat. The more important of these trends, shown in Figure 1, parallel trends in the demands for these commodities. But this relation is too simple to be relied on for purposes of pro jection, although it is very suggestive. Fundamental condi tions affecting futures trading need to be examined. If it were possible to organize agriculture so that only pipe line stocks were to exist, there probably would be little or ganized futures trading.81 A considerable investment would, of course, be required to carry stocks through the processes of growing, fabricating, and distribution. It might be financed in any number of ways as shown in the previous section, but organized futures trading probably would not be one of them. Forward trading under less highly standardized methods might be. The essential role of futures trading is no different than other forward trading but conditions for its success are dif ferent. When futures trading is functioning well, a large commodity debt structure becomes erected on a small base of immediately deliverable commodity stocks. However, large supplies can be put into position for delivery at a relatively nominal cost if necessary in order to satisfy all who want delivery. This structure of deliverable reserves provides in tegrity to futures contracts without interfering with the phys ical flow of commodities. It requires that there be many operators who would gladly sell stocks they do not need im mediately and instead would purchase stocks for later de livery if they see a small profit (or reduce their costs).

81 It is not readily apparent what pipeline stocks consist of. Stocks that look like they would be free from an engineer's viewpoint of the commodity marketing system may not be free to move. There are many possible reasons for this. One case is described by William T. Wesson, Possibilities For Futures Trading in Florida Citrus Fruit and Products, U. S. Dept. of Agr. Agricultural Marketing Service, Marketing Research Report, No. 156, Feb. 1957. pp. 18. [233] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

If there were only pipeline stocks in a marketing system, no one could stand for futures delivery without threatening to disrupt physical operations. It would be too costly for firms to release stocks and, hence, prices for immediate de livery of the commodity could be forced up arbitrarily. With distorted price relations, many firms could not sell their serv ices to advantage by use of futures contracts. It is very unlikely that, in the foreseeable future, pipeline organization will occur in the commodity marketing system for farm crops. By and large, crops will continue to be grown in the field rather than in the greenhouse. The har vests will follow the cycle of the seasons in each hemisphere, and will be bunched. Also, there probably will continue to be important variations in the annual harvests due to weather. Livestock and livestock products are somewhat different. The traditional seasonal production cycle has been damped. Egg and broiler production seem fairly level and milk, beef, and pork are tending in this direction. If a pipeline organiza tion is shaping up, the growth potentials for futures trading in livestock products would appear to be small or non existent. But one can generalize too readily. The three-fold increase in futures trading in eggs over a period when the quantities of storage eggs declined does not fit this explanation.82 Eggs

83 We are in search of the reason and offer the following as a possibility. The Chicago shell egg futures contract has been improved. Among other things, the supply base for delivery on egg futures has been broadened to permit delivery of better qualities of fresh eggs at a premium over contract quality eggs (which may be either storage eggs or fresh eggs.) This action may have lowered the squeeze potential permitted by the former storage egg contract. It now seems foolish for anyone to squeeze the egg market by gaining control over the deliverable cold-storage stocks and then standing for delivery on a sizeable position in egg futures. In such cases, he would get delivery of quality fresh eggs for which he would have to pay a premium but he could not hold these off the market very long lest they deteriorate to storage quality. The futures contract itself does not allow payment of a premium on fresh eggs delivered if they have been stored for more than 25 days. Thus, eggs really cannot be drawn out of the pipelines for long except at a loss. (The legal limits imposed on speculative futures positions might also inhibit the squeeze.) Cont. [234] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING may be an important exception to our generalization that futures trading in livestock products has a limited po tential. One must be careful to note other potential excep tions. There are relatively few animal products in which there is futures trading, and, while this fact gives support to our general thesis, the development of futures trading in one or two important animal products could continue the trend shown in Figure 7. For example, there is fairly extensive forward buying and selling of feeder cattle which suggests the importance of dividing up the enterprise of rais ing cattle among different parties. But whether futures trad ing in live feeder cattle will ever develop out of these pre conditions is a matter for conjecture. The evidence for projecting a continuation of the in crease in futures trading in feeds appears fairly good. There will be an increasing volume of feeds grown and fed to live stock as the economy expands. Secondly, there is a definite trend toward specialization between growing feed crops and growing animals. Were every farm to balance its crop and livestock production, no feed would be bought and sold. At the other extreme, were one group of farmers to grow the feed and another the livestock, then all feed would be bought and sold. The actual situation lies nearer the former but it has taken a large stride toward the latter in recent decades. In 1936-41, only 9 percent of the corn fed to livestock was pur chased in some form; in 1951-55, over 21 percent was pur chased. Soybean meal fed to livestock doubled in a few years. Corn and soybean meal have provided the impetus to the upward movement of our index of futures trading in Some egg dealers scattered throughout the country may have discovered a worthwhile method of financing their operations through hedging in futures, even if the average hedged position is kept for only a few weeks. In year-around fresh egg merchandising, a dealer may hold a perpetual inventory of fresh eggs against which he may have a perpetual hedge in futures. If so, futures trading in shell eggs may facilitate a division of enterprise so that the small dealer with a little niche in the market can compete as a specialist. [235] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR feeds. The forces underlying specialization in feed concen trate production appear to be strong. We anticipate further specialization, greater subdivision of enterprise, and an in creasing potential for futures trading. A continuation of increased use of corn for industrial and food uses seems certain and while this influence would be much less important than sales of corn for livestock feeding it must be counted as a growth element.83 The future of futures trading in the great export staples is not as clear-cut. The long range trend has been down. It seems to reflect, basically, the long range decline in export demands and the failure of domestic demands to grow with the economy. Price-supports have been operative and they are the aproximate cause of the decrease in futures trad ing activity, especially in recent years. The long range future demand for American cotton and wheat will determine, es sentially, the level of futures activity. Any change in support programs will exert a marked influence over shorter periods. In this respect, there may be more room for an increase than for a decrease in futures trading in the export staples be cause effective support levels already exert a large effect. There should be noted at least one important structural change that has tended to increase the amount of futures trading. Cotton production has shifted from relatively small operations to relatively large commercial operations, especial ly to the irrigated areas. In the latter, much of the growing of cotton has been financed directly or indirectly by hedg ing in cotton futures. We do not know the current extent of such financing and its future possibilities.

3 The percentage of total corn production sold off of farms increased steadily from the 1931-35 period to the 1956-58 period. In the early period 17 percent was sold; in the latter, 35 percent. Of the increased amount moving off of farms, about three-quarters was used in livestock production and about one- seventh was used in industrial and food uses. (Based on data in Agricultural Statistics.) [236] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING

For purposes of further inquiry, these appraisals of futures trading by commodity groups may be cast into a tentative projection of total futures trading. Our studies up to this time may not warrant more than a loose projection but even this can serve a useful purpose. We judge that the long-term trend of our index of futures trading will be sideways to up. Even if there were a con tinued downward drift in futures trading in the export sta ples, this probably would be offset by a continued upward drift in futures trading in feeds. On the other hand, a level ing of the futures index for export staples would permit a rise in the over-all index, and a rise in the export staple would mean a substantial increase in the overall index. It must be noted however that the retention of the index of futures trading at a constant level over the next two decades would denote a declining role for futures trading assuming a continued growth in the over-all economy. To gain further insight into the future of futures trading, we shall subject this projection to several tests. It may be asked whether these projections are more optimistic than warranted by the structural changes in the economy in which the role of the market in organizing economic activity is being increasingly supplanted by the role of administrative deci sions. Selected features will be examined, namely, the ten dencies toward multiproduct lines, contract farming, vertical integration, technology and related matters. Multi-product lines. — The American economy, with its rising real per capita incomes and rapidly changing technolo gies, has created a flood of new products. The great pro liferation in sizes, shapes, and forms of items is largely the result of harnessing new technological possibilities in manu facture to fill the flexible demands of a people with relatively high and rising real incomes. In the selling of a multi-product [237] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR line there are introduced elements of administrative pricing sometimes referred to as a firm's "price policy." Has this so pervaded the markets that the competitive relations, on which futures trading depends, have been eroded? Futures trading is seldom applicable to late stages of the marketing channel. It is applicable to raw materials and semi-processed products. Neither of these have been signifi cantly differentiated into multi-product lines. Hence, the tendencies described here are not directly relevant. Yet, there is a relevant connection between the prolifera tion of end-items and futures trading in the basic materials. The two seem to be mutually supporting. A flour-mix manu facturer discovers that it is profitable to tool up to convert widely available materials into an entire line of packaged items which differ by formula, size of package, label and so on. Such enterprise becomes profitable if his capital is not tied up in excess inventories. In business parlance, the annual turn of capital needs to be high in order to make an attractive rate of profit on a relatively narrow mark-up. The possibility for engaging in a profitable operation depends on a marketing system in which commodity stocks are carried economically and are economically delivered to the flour- mix manufacturer when, where, and how often he wishes. To show how the development of new manufactured items affects the raw materials market, consider the expanding po tato processing industry. Only in an economy of advancing incomes would one expect potatoes to be consumed in such expensive forms. In order to sell manufactured potato products forward at fixed prices in advance of having ob tained the potatoes required, some manufacturers commit their assets to a supply of potatoes by purchasing potato futures. Their additional buying and selling tends to im-

THE FUTURE OF FUTURES TRADING prove the competitive character of the potato market.84 Contract farming. — What about the influence of "con tract farming" on futures trading? What modifications might need to be made in our projections? It was brought out in the previous section that contract farming is alternative to forward trading in dividing up an enterprise and separately transferring the parts. It is more flexible in adaptation to certain circumstances. There are various areas where both forms are in evidence, e.g. in rais ing of potatoes, eggs, and perhaps feeder cattle. Both may be viewed as responses to a common set of economic forces, and yet each could be viewed as a substitute for the other. The two aspects are informative. Where contract farming has grown most rapidly, it has been a factor that has encouraged futures trading. If it is true that the financing of broiler production through con tract farming has made possible the low price of poultry meat and the vast expansion of output, then it has resulted in an increased demand for soybean meal and, indirectly, for soybeans. This has stimulated soybean production and futures trading in soybeans and soybean products. If con ditions become favorable to further specialization of live stock production, we can expect to see more of this. Vertical integration. — The magnitude of vertical integra tion is measured by the extent to which resources are allocated by administrative decision rather than through buying and selling in the market. In general, vertical integration is an opposite type of development from futures trading and the two seem incompatible. However, to appraise the effect of vertical integration we need to know more about where and

4 For some insight into the operations of potato chip manufacturers see the testimony of Donald W. Reed, Futures Trading, Hearings before the Special Subcommittee of the Committee on Agr., House of Representatives, Dec. 6, 1955. pp. 54-56. [239] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR what kinds of integration have been occurring. From some very general data of the Census Bureau and scattered bits of evidence, the following impressions seem warranted.86 Vertical integration of retail grocers into wholesale grocery warehousing is not directly relevant to futures trading, nor is the general increase of manufacturers branch house sales relevant. Futures trading seldom occurs in the intermediate products of these integrated firms and, therefore, it is not directly displaced. On the other hand, the extension of re tailers into manufacturing operations might be significant. However, the evidence is to the contrary. The importance of retailers in manufacturing does not appear to be very sub stantial.86 Retailers account for perhaps 10 or 15 percent of the total bread and coffee products manufacture. Their in roads into canning, freezing and confectionary, and dairy products manufacture appear to be much smaller. More over, when retailers integrate, it is our impression that they favor enterprises which allow them to turn their capital relatively rapidly. Thus, a decision to assume responsibility for a processing enterprise may turn on having a system to carry the stocks and to supply them ingredients as required.

The move by a processor into a prior or later stage of manu facture tends to supplant the buying and selling of the in termediate products. Yet the cheapest ingredients frequent ly are not one's own. The few facts we have do not support the view that unified control of two sequentially related stag es of manufacture has resulted in a large decline in market dealings, at least for some products that are important in fu tures trading. For example, in the soybean milling industry

86 Company Statistics, U. S. Bureau of the Census, 1958. Table 3. 86 However, from the viewpoint of the firm, the importance of such manufac turing may be quite substantial. [240] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING only 10 percent of the oil and meal were transferred to an other plant of the milling firm in 1954. Yet several times this quantity would have had to be transferred if the plants were to operate substantially on a vertically integrated basis. The combination of manufacturing and assembly is im portant in the grain trade. Evidently, there is a widespread reliance on market prices to direct the movement and use of grain in spite of this. The move of manufacturers and whole salers into agriculture has been substantial in canning and freezing crops. But, in areas where futures trading counts such moves seem to be of little magnitude. Farmers have moved into assembly, wholesaling, and even processing through farmer owned cooperatives and through various other arrangements as in beet sugar production and citrus concentrate production. Intermediate stage market pricing tends to disappear. How these bear on futures trad ing depends a good deal on the commodity areas involved. Dairy products and fruit and vegetable merchandising and manufacture are little involved in futures trading. The out put of sugar mills is traded on futures. In none of the foregoing discussion have we considered the use of futures price quotations by market firms, including those which make an administrative decision of the prices at which its products are transferred between its plants. The reliance on such central market price quotations permeates the entire market. Technology and related matters. — Society has developed various ways and degrees of underwriting enterprises. One consequence of this seems to be more rapid technological change.87 In a growing economy, there will continue to be

87 See, for example, R. W. Gray, Vernon L. Sorenson, and Willard W. Cochrane, The Impact of Government Programs on the Potato Industry, of the United States, University of Minnesota, Agricultural Experiment Station, North Central Regional Publication No. 42, 1954. [241] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR many competing uses for capital, consequently, many firms would find it necessary to specialize their enterprises in order to adopt new technology. In food and agriculture, the poten tial for changing the technology of production still appears to be large. Abstracting from the possible role of the CCC in carrying stocks, one may legitimately ask why more firms ultimately will not want to carry their own stocks. Conversely, if they choose to let others carry the stocks why can they count on others to do so? It is hard to give a final answer to this query, but it should be observed that the law of comparative advantage favors a continued division of enterprise, much as between the specu lator and hedger. The enterprise of carrying commodities is unlike the enterprise of producing the services by which commodities are transferred in time, place, and form. For one thing, success of the former enterprise does not depend nearly as much on scale. Decisions to carry stocks are likely to be no more right because they are made in progressively larger units, than in the smaller units. The economic entity with large amounts of assets has more to gain by specializing in enterprises where there are definite economies of scale. This almost inevitably involves physical operations. Second ly, the income tax laws have become more influential in shaping economic decisions than years ago and this is likely to continue. Individuals who take the responsibility for carrying commodities forward for more than six months, often pay only half the rate paid by commodity businesses that do the same. To obtain the same after tax return on such investment, the former needs to be only one-half as profit able as the investment of the latter.

THE FUTURE OF FUTURES TRADING more questions for examination than we have settled. The competitive organization of commodity markets is a highly complex phenomenon and knowledge is not easily come by. We have tried to ask the most relevant questions and fur nish answers where we have found them. If a generalization on the future of futures trading is war ranted, it is this: The weight of evidence examined does not support the view that the emerging structural changes in agri cultural commodity markets are, on balance, more unfavor able than favorable to futures trading, even though there are important exceptions. Admittedly, much relevant evidence on the nature of the emerging market structure remains to be examined or is lacking altogether, and this paper is to be regarded as a preliminary effort. Also, there is a major omission. Consideration has not been given to trends in horizontal integration, or more gen erally, to the emerging private sources of market power. The concentration of market power might greatly limit futures trading. It is not obvious what the significant trends in con centration are and how and to what degree they affect fu tures trading. Analysis would require a conception of the nature and areas of market power that is consistent with the conception of the nature and areas of enterprise in which such power is effective before the measurements are attempt ed. Time does not allow us to pursue this inquiry. The most easily identifiable influences in the failure of futures trading as a whole to grow over the past thirty years are in the two export crops — wheat and cotton. The basic factors are the changing market position of the two commodi ties and, interrelated with this, the support of prices and in creased State trading. The composition of commodities in futures trading has shifted over years. Some that once were very active are now very inactive or have disappeared — like

FUTURES TRADING SEMINAR trading in pork provisions and butter. Trading in some com modities has been attempted without much success to date, e.g. in canned vegetables, dressed poultry, live hogs, frozen eggs, cheese, apples, millfeeds, rice, and others. Trading in some commodities has grown to relatively large volumes, as soybeans, soybean oil and meal, eggs, and potatoes. The shifting composition is by and large a response to a set of forces arising out of the structural organization and the needs of individual commodity sectors. An observation that can be made on the basis of our in quiry is that it is not readily apparent that the administrator's role has increased relative to the market's role in organizing resources. In an expanding economy there could be more of both. Moreover, the areas of influence of each may be quite different and even mutually supporting. Much of what is counted as administrative allocation of resources is actually based either directly or indirectly on competitive prices. In this setting, a small improvement in arrangements by which trade occurs has a larger significance. There is evidence of the frequent operation of what we shall term the principle of competitive reinforcement, namely, one improvement begets another. Finally, our paper does not furnish an adequate basis for suggesting desirable changes to be made in the enterprise or ganization of the agricultural commodity marketing system. This presumes a much broader inquiry of the nature, pur poses, and consequences of economic arrangements than we have made.

The Future of Futures Trading Walter M. Goldschmidt

It was rewarding to work with this objective appraisal of the outlook for futures. It was also refreshing to note signs of optimism regarding the prospects for our futures trading. I would like to commend Dr. Paul on this work — it is a contribution to the better understanding of futures. In my role as a discussant, my first approach to this paper was an attempt to be critical; however, Dr. Paul has a thor ough understanding of the subject matter, and disarmed any critic by limiting and charting the course of his inquiry care fully. I find the only contribution I can make to the subject of the "Future of Futures in our Changing Agriculture", is to add a few remarks as appraised by one having only cursory knowledge of the intricacies of economics, but being active in the application of futures — grain futures to be specific. What I have to say does not contradict Dr. Paul, it is mere ly a shift of emphasis, and then only as it applies to the futures traded at the U.S. grain exchanges. Being active on the Exchange floor of the Board of Trade daily, I am overly impressed with the dwindling volume of futures trade, which has moved from a high in the post-World- War-One era of 30 billion bushels per year to a post-World- War-Two high of 14 billion 200 million bushels achieved in 1956. The steady decline since 1956 is particularly alarm ing. The 1957 volume was 12 billion 800 million bushels — a 9.6% decline. In 1958 our volume was 11 billion 336 mil lion bushels — another 11.7% decline, and the first six months of 1959 shows a decline of 16% over the like period in 1958. The decline in dollar volume is even more pronounced since we have had a decline in prices. This decline in volume has occurred while the volumes of most other segments of [245] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR our economy have been and are steadily expanding. Even more disturbing is the fact that while total volume of futures trading has alarmingly declined, the total annual produc tion of the same group of commodities has significantly in creased, denoting that the decline of the proportionate use of Futures is even greater than the decline in volume. Plotting total production versus total volume of futures trades in the post-World-War-Two period, there appears to be an inverse correlation. One explanation is that, as production goes up, government influences on prices and marketing becomes greater, and volume of futures trading declines. It is usually more than one factor which influences a com plex mechanism such as a commodities futures market, but the evidence seems to point that government activity in agriculture is the prime deterent to the expansion of volume in grain futures. To what extent government activities have influenced grain trading is difficult to estimate, but we know that for years it has counteracted the growth trends men tioned by Dr. Paul, and in recent years undoubtedly caused the severe declines. Of course, I agree with Dr. Paul that vertical integration is not compatible either with expanding volume of futures trading, but that influence has been rela tively insignificant. How and why government activity has affected the volume of futures trading adversely I am sure is obvious to you, and can be illustrated very simply. Persons using futures markets fall into two broad groups: First — those seeking to minimize their business risks — the hedgers; and Second — those will ing to assume these risks — the speculators or investors. How does the government interference affect each? First, the Hedger: For this let us divide the agricultural industry into three categories, producers; distributors and

[246] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING merchandisers; and processors. The largest volume of hedges has come from those engaged in distributing and merchandis ing — the second from processors, and least of all from the producers. Government activities have influenced all three segments of the industry to be sure. It has stimulated pro duction for the producer, has provided processors with a supply of raw materials, but has to a large extent, supplanted the marketing and distributing segment of the agricultural industry. Most of the producers growing grain in excess of their needs will either try to hold as much of the grain as they can for the loan price, or will put it into the loan, both instances eliminating a hedge as the grain is carried for ward, thereby also reducing the amount of grain marketed through private channels. Secondly, even the grain which is handled through normal channels is often not hedged be cause of government price setting influences. The Commodity Credit Corporation has become the larg est grain merchandiser in the world, supplanting private en terprise. The displaced private enterprise has taken up the function of warehousing the government surpluses, largely neglecting the merchandising functions, and relying upon storage revenue. This rapid expansion of grain storage is creating enterprises dependent entirely upon government- owned surpluses. It is not building a sound system of dis tributing and marketing grain, and may eventually result in greater concentration of marketing power, which as Dr. Paul mentioned may be a deterrent to the volume of futures trading in the long run. Second, the Speculator: He is faced with an entirely dif ferent set of circumstances, but is, however, equally dis couraged in using futures in which the government is the controlling influence. Not only is the volume of hedging reduced in those futures but the speculator's analysis of a [247] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR situation can over night be reversed by some Government edict. In addition, the security markets have been active, and have attracted speculative capital. As a matter of fact, public participation in the grain futures market is at such a low point that it scarcely pays for commercial institutions, sell ing investors, to maintain commodity departments. Should this volume of trade be reduced even further, it will reduce the number of brokerage and commission houses participat ing in the grain futures business. This will certainly have a cumulative effect on reducing the volume of trade even further. This is not an attempt to be particularly critical of govern ment activity in agriculture, which is a subject of its own. But from where I view it, I can see, feel and taste government activity in the grain industry so strongly that I can only see a future in futures if some of that activity can be curtailed. There are at the present time some activities taking place which appear constructive to the private trade, and conse quently to an increased volume of futures trade. The effects up to now have only been able to prevent a sharper decline than we have already experienced, but may in the long run help reverse the present down trend. 1. Subsidy in Kind Export Program: The recently adopted subsidy in kind export program — designed to channel the flow of grain through more normal channels, by permitting the exporters to secure their grain in the% free market and by Commodity Credit Corporation supplying from their stock only that portion which is repre sented by the subsidy. Any additional grain that CCC. may be forced to sell is to be introduced into the market stream as close to the source where it is produced as is feasible. The subsidy in kind export program has resulted in the pri-

[248] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING vate trade handling more grain, and has partially brought the exporters back into the futures market, and consequently has prevented the volume of futures from falling lower than it has. This program has been operative for wheat for two years, and over one year for feed grains. The reason that this program has not been more effective in aiding our vol ume of trade is because there are several programs in effect which have an effect of circumventing the subsidy in kind program, namely: The Barter Program, and the G.S.M. 1, un der which CCC stocks may be sold for credit to qualified countries. However, as long as we have Government owned surpluses, the subsidy in kind program is as good as any program devised, and if permitted to operate will be a con structive influence on the preservation of the grain market ing industry and the volume of grain futures trading. 2. Recent Reduction of Supports Secretary of Agriculture Benson, who for years has been fighting economic battles with political tools has pressed for a gradual reduction of price supports. This year supports of some of the major feed grains were substantially reduced and acreage restrictions freed. Some major shifts of acreage have already occurred. Soybeans, oats, and rye acreage, and consequently crops, have adjusted closer to demand, and we will find that this crop year Commodity Credit Corporation will have less influence on those commodities, and I can fore see that these futures will be more active.

3. Future of Our Farm Program: Here I am perhaps overly optimistic. In a report by Secre tary of Agriculture Benson to Congress a year ago, he stated, and I quote in part: "By 1975 we will probably have mar kets for some 40-50% more farm products than today . . . a continued uptrend in production in prospect for most farm [249] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR products is expected to fully keep pace with the growth in demand. This situation, together with present large stocks indicates that for the next decade a major agricultural prob lem will be to bring about a balance between production and consumption." This, after over twenty years of experiment ing, and billions of dollars spent. We have tried everything but to leave the farmer alone. We have learned in elementary economics that over-produc tion in agriculture can only be cured by: 1. The withdrawal of sub-marginal land from planting. 2. The further transference of part of our agricultural population to more gainful occupation, and 3. That in time the working of the price system will bring this about. Since this is basic knowledge, it appears that the farm prob lem is not a farm problem but rather a social problem nur tured by political attempts to save the family farm — a unit which has proven to be inefficient in our mass market and mass economy. All of us realize fully that price supports cannot be elimi nated without creating hardships, and it should be accomp lished through evolution, not revolution. There is no doubt that the protective tariffs for industry work to the disadvan tage of the farmer because they raise the price of the things he buys while they injure the foreign markets for his prod ucts, but we must continue to strive to reduce price supports further to a point where they only cover the cost of production for the efficient producer, eliminating the incentive to pro duce and the inefficient producers. As farm population de clines, the change will be more expedient politically. My optimism for the future of agriculture is based on the fact that I do not believe that we can, over the long run, per petuate an inefficient unit of production by legislation, un- [250] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING less the country as a whole is willing and able to pay the entire cost and far reaching consequences. For example, it just isn't sound that a consumer should be taxed to keep land in idleness — so that he has to pay more for what is pro duced on the rest of the land. The system will either have to be changed, be bailed out through some disaster, or col lapse from its own weight. There is no doubt that resolute steps must be taken soon, and when they are taken, I fore see further concentration of farm land, increased productivity through specialization, automation, and advances in technol ogy. The investment of capital for a farm worker will increase immeasurably. The farm will simulate factories in efficiency. They will produce profitably at lower prices. The use of futures markets by the larger and more efficient farmers will complement their operation and perhaps crops will be hedged as they are planted, or even before. Under such a system one can easily visualize a great potential increased use of futures markets. 4. Education: A further factor which is constructive to futures markets is education. Education motivated our appearance here today, and the implication and importance of it I need not stress. 5. Continued efforts by futures markets to help in: a. Reducing government influence on agriculture. b. Educating all concerned in what futures are and do. c. Conducting research which may result in the creation of new futures, and d. Maintaining a futures market suitable to serve all seg ments of the industry. In Summary To the constructive factors for an increased use of futures markets cited by Dr. Paul, I can merely add these a. Short term effects namely: [251] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

1. The subsidy in kind export program. 2. Present reductions of the support levels, b. Those of a more long term nature are: 1. That we cannot indefinitely sustain the present Farm Program. 2. Education. While, in balance, our inquiry seems to indicate an increased use of futures, I must caution against complacency since the only promising outlook for futures markets is in the creation and maintenance of a sound, efficient, privately operated sys tem of producing, marketing and processing agricultural products.

The Future of Futures Trading Leonard W. Schruben The paper here reviewed is a rather detailed statement of the authors views on: (1) the nature of futures trading, (2) trends in market organization, (3) effects of these trends on futures trading and (4) general conclusions. The authors initiate their discussion by asking why proof of the contribution of futures trading must so often be pro vided. They suggest the method of analysis and issues in volved need to be conceived differently. In this context, they propose that futures trading is one of the many financial institutions in a well-developed economy. This view places futures trading in the category of insti tutions which make it possible to achieve economy of scale in segments of the economy touched by it. After all, revolv ing capital is scarce. Assets held in reserve to meet risk of price change is a cost which can be only partially recovered in the investment market. When a small part of risk funds can be used to shift risk, as in hedging, a higher proportion of assets can be used in the operation of the business. Futures trading thus is a financial institution. This con cept will not relieve the necessity for frequent, and some times painful, review of the place of organized futures trad ing in our economy. The basic question will always be pres ent: Is this activity necessary? Does it perform a useful function? Who uses it and for what purpose? Questions pointed out but initially bypassed by the au thors involve an appraisal of the future prospects for price uncertainty, changing incentives for shifting risk, and the interest of different individuals in risk assumption. This reviewer would feel more comfortable had the authors met these questions head on. [253] ©1960 Mimir Publishers, Inc.

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As one continues to read, it becomes increasingly apparent that Paul and Wesson have no intention of making sweeping generalizations regarding the future of futures trading. For example, they point out such trends as size, number, speciali zation, capital needs, etc. of market units. But they do not directly relate the consequence of changes of each to the main topic under discussion. Why then bring these topics into the discussion? Let us be fair about this. After all, the authors were given the impossible task of prediction of future events. No one yet has discovered a method of forecasting coming events which will always result in a correct forecast. However, more conjecture by the writers from their vantage point of experi ence would be welcome. What about the future of futures trading? Where is this social institution headed? Paul and Wesson conclude that on balance the future is as likely to treat futures trading kindly as not. The emergence of any social organization is in response to a felt need on the part of some one or group. When the need disappears, the social organization vanishes. However, so cial organizations created in response to a given set of con ditions may very well continue to exist to serve another and possible different set of conditions. Thus futures trading, initially established in Chicago to help traders down state buy and sell corn today serves an enlarged purpose. But futures trading cannot exist unless it performs a useful function more efficiently than that function can be performed by other methods. Time lag forced by custom, habit or market power is excepted. One of the functions of futures trading is to shift market risk from those less able or less willing to those more willing to bear it. In short, to provide hedging. The present form [254] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING of futures trading cannot exist without hedging. For example, there is no wheat futures trading on the Winnipeg Exchange. Yet it is not prohibited by law. It just isn't practical because there would not be a useful, needed function performed. A futures contract would not culminate in a delivery. Hence a dead market. Contract farming and vertical integration are viewed by some observers as threats to futures trading. Paul and Wes son point out some significant differences. It would be well for further observations to be made as to the future of this development. For example, there is a relatively new business firm in Kansas City which offers a "coordination from farm to market" service. Farmers own productive resources, feed manufacturers own productive resources and retail stores act independently. All three are brought together by a team of specialists. Individual experts in nutrition, mill operation, ingredient purchasing, farm production and marketing com pose the team. Such a team offers expert help to a number of small es tablishments which formerly was available only to large firms who could utilize the full-time services of specialists. Should this firm continue successful operation it is certain to be duplicated. Before long the whole concept of integration could change. A development of this nature would open op portunities for futures trading. It has been a stimulating experience to study the paper under review. I recommend it be studied carefully by others. While you may not agree with the authors' position you will find the subject, the future of futures trading, a challenge to constructive thinking of your own.

The Future of Futures Trading Adlowe L. Larson The authors of our paper have presented in a scholarly manner their views on "The Future of Futures Trading in Our Changing Agriculture". In doing this they subdivided the area into three sections: (1) the nature of futures trad ing, (2) basic tendencies in market organization, and (3) the bearing of structural changes on futures trading. The introduction, discussing the role of futures trading, presents a series of views, but leaves one not certain as to the point of view of the authors. Perhaps that is as it should be. The classical or usual approach to futures trading which centers on price risks and their shifting is rejected as a method of approach and yet one feels in reading the paper that it is not rejected. They adopt instead the Brookings approach, developed under Rowe, "that futures trading is one of the many financial institutions of a well-developed exchange economy." In part one, concerned with the nature of futures trad ing, the idea of futures trading as a facilitating financing in stitution is presented using aids of Boulding, Hawtrey, Lerner Usher, Rowe, Hicks, Hart, Working and Commons in addi tion to Congressional hearings. Through futures trading marketing activity over time is facilitated. Borrowing is aided as is also specialization in most market levels and seg ments. More effective use of resources becomes possible through it. Speculation and hedging are differentiated in an unusual manner. The distinction is between "carrying stocks through time" [speculator] and "providing the services required to carry them" [hedging]. The distinction appears to be be tween price and non-price services. Whether it will be useful or not remains to be seen. [257] ©1960 Mimir Publishers, Inc.

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The portion of the discussion ending with Commons and his Institutional Economics brings out important institutional changes, including the discovery that a debt is a property. In fact, most of part one concerns Institutional Economics. In part two, concerned with basic tendencies in market organization, attention is given to numbers and size of op erating units, to specialization, sources of capital, and to enterprise division. While numbers of most firms of agricul ture, its marketing, and its processing have declined sharply, those of wholesaling have increased. Except for retailing, whose picture is not clear, there is increasing specialization. Corporate methods of financing are important in the entire food economy. As added size is necessary to secure specializa tion and scale gains, there are increased financing require ments. Although I did not find this tied to futures trading, the inference, I expect, is that futures trading is an aid in this financing. In part three, concerned with the bearing of structural changes on futures trading, the discussion deals with trends in futures trading, multiproduct lines, contract farming, and technology and related matters. The long time trend in fu tures trading is forecast as "sideways to up". It is influenced by price-supports (a substitute in the minds of those using them). It has strength in feeds, animal products, and semi- perishable crops and weakness in cotton and wheat. The authors state that contract farming has encouraged futures trading, but that vertical integration and futures trading seem incompatible.

The following comments are in addition to rather than criticism of the paper. They are related to changes in market structure and market prices. They are based upon the major changes going on in agribusiness with (1) fewer and larger [258] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING farms operating with improved technology, (2) fewer and different assembling or country markets, (3) the increasing number and more highly specialized wholesaling markets, (4) fewer and larger processing plants, and (5) the large scale retailing machine with its increasing and perhaps domi nant market strength. All of this is coupled with major chang es outside agribusiness in manufacturing, merchandising, and living. In the past futures trading has been associated with a sys tem, such as with wheat, in which many producers sold wheat to many local elevators who in turn sold to buyers in terminal markets. Much of this market was thought of as approaching purely competitive conditions with firms at the same level and different levels acting independently, not influencing price, and merchandising a standardized product. Hedging was done mainly by terminal buyers to whom local assemblers sold as soon as they bought the wheat. Price alone through spot or time sales regulated the market flow. While this sit uation may have been a myth, in the future it will not in my opinion be nearly so closely approached as in the past. The situation which futures trading will face in the future is an increasingly integrated economy, tending to be domi nated by large scale retailing.88 This horizontal and vertical combination through ownership and formal and informal arrangements will tend to lessen the importance of price as a market-integrating factor. Integration will be more through purchasing contracts or specification buying. Price agree ments will tend to spread from those having the market pow er — increasingly the large scale food retailers. Others, includ-

8 George L. Mehren, "The Changing Structure of the Food Market," Journal of Farm Economics, Vol. XXXIX (2), May, 1957, pp. 339-353. Norman R. Collins and John A. Jamison, "Mass Merchandising and the Agricultural Producer," Journal of Marketing, Vol. 22 (4), April, 1958, pp. 357-366. [259] ©1960 Mimir Publishers, Inc.

FUTURES TRADING SEMINAR ing local assemblers and terminal buyers of food products, will have less need to hedge for price protection if protection can be obtained through contractual arrangements. If the large scale food retailers will continue to increase their market power, what are the possibilities of increased use of futures by them? While margins are increasingly com petitive at the retail level, retail prices do not fluctuate as much as in wholesale markets. This competitiveness might encourage them to hedge to protect longer term positions or for financing reasons, but the lack of major day to day price fluctuations would not encourage hedging. Furthermore, products handled at retail are mainly processed, while those sold on futures markets are not. Is this an impossible situation if true? In answering this, let us look at major patterns only and let someone else worry about the sewing. The position is difficult but adjustment to these changing conditions may bring new opportunities to futures trading organizations and services to society. While government price guarantees as used have lessened the need and demand for futures trading, I would not expect the elimi nation of them to bring back futures trading where it was. Adaptations must also be made to the changing market struc ture with its emphasis on contracts and increasing power of the retailer.

Would it not be possible to have a modern version of the early day mail order house "piano-hedge" to fit requirements, existing or potential, of the large scale retailer? The answer would likely not be in just having more commodity futures, although wheat futures could not be expected to give price protection to the some 5,000 to 6,000 items handled by to day's supermarket. If this retailer is to use futures trading appreciably in hedging contracts he makes to suppliers, he

THE FUTURE OF FUTURES TRADING will likely want to see that the fluctuations in differences are less than those in spot prices. Several questions may indicate what is desirable to this retailer. What do the retailers want? For which departments or food areas will individual commodity futures hedges give price protection or financing aid? Will a combination of several futures serve better in some areas? What feasible new futures, singly or in combination, would provide fea tures wanted? Can combination "futures-packages" be se cured or must they be tailor-made by the customer? Should the futures exchange check to see what the requirements of these potential customers are? Should it merchandise its serv ices in combination packages — like the TV dinner, a com posite contract for food? Or if done, should this be left to brokerage houses? More specifically, can the hedge be better merchandised? The term "hedge" means different things to different peo ple as can be seen, for example, by comparing the concept in the paper presented with that of Holbrook Working89 or with the usual textbook or Board of Trade example. From the point of view of an organization selling the hedging service to new or relatively uninformed customers, there must be a common understanding as to what the service is. In conclusion, I wish to compliment Paul and Wesson for the job they have done in looking ahead. It is my belief that added recognition must be given by futures exchanges to structural changes now going on in the food marketing sys tem, and that attempts should be made to modify in part, at least, futures trading operations to fit the needs of the system.

The Future of Futures Trading Discussion MELOAN: The final session is now open for question or comment. Perhaps Dr. Paul has some rebuttal. PAUL: It may be possible to clarify the paper a little in the light of some of the comments. Now, I may ramble but I will try to leave a total impression rather than to pick on iso lated points. Adlowe has rendered the service of trying to further extend the view of where futures trading eventually may fit. He looks at one of the large changes that is taking place — the growth of the large food retailer and his changing merchan dising activities — and suggests the possibility of futures trad ing in retail goods. I will venture an opinion on some of the reasons why such futures trading is not likely to develop. Retailers have organized their business with kinds of fi nancial arrangements that dispense with any direct need for futures trading. They free their own capital by leasing stores and equipment. And while they have a large investment in stocks, which are turned rapidly, they seem to be continually indebted to their suppliers. Their accounts payable greatly exceed their accounts receivable. For food manufacturers, it is just the other way around; their accounts receivable ex ceed their accounts payable. This is a point we tried to make in our paper: that is, to understand whether there is a place for futures trading one must examine the totality of financial relations. The large retailers have various serviceable ways of arranging for the outside investment required to engage in their business and therefore have no real need for using futures. Furthermore, the great proliferation of manufactured items, in their many specifications, seems adverse to establishing a workable con tract. By contrast, there has not been much change in the [262] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING physical nature of raw agricultural products over the years. While you get more oil per bushel of soybeans today, the bean is still oil and meal in combination. And while protein values in wheat have gone up, wheat still hasn't changed much; and so on down the line. These are the staples of com merce for which there can be a broad interest in futures trading. Now, if we were to pursue the specific reasons for futures trading in staples, we would be off on a long dis course. Where the retailers have engaged in contract buying of supplies — the specification buying of fruit and vegetables and meat — there is no futures trading. And there may be no potential for it. The question of concentration of power that Adlowe raised, its meaning for futures trading, is one we haven't examined. Turning to the basic question of whether we have ac cepted or rejected the conventional concept of futures trad ing, risk shifting and so on. Professor Schruben, who has al ready left, raised the same question. Our discussants are very perceptive. When I sent them a working draft I said they could base their discussion firmly on what we gave them; it would not be changed much. I think all we did subsequently was to edit the paper a little and insert a page and one half elaborating on the financial nature of futures trading. But we did one other thing to cover a gap. A footnote now clari fies whether we accept or reject the conventional explanation of futures trading. I don't like the words "accept or reject". You make a choice for a purpose. Do you accept or reject usual geometry when you use non-Euclidian geometry? Do you accept or reject a concept of the world being flat when you choose to be guided by a road map? We commonly say that the sun rises in the east and sets in the west, when the sun doesn't

[263] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR move about the earth. It is serviceable to say that the sun rises in the east and sets in the west. Everybody knows what you are talking about except somebody on the North Pole perhaps. But it is not very serviceable when you are trying to explain the relation between the planets. What we say is that the conventional explanation of fu tures trading is serviceable to a point. It has some mythology in it, i.e. characterizing every transaction as to shifting of risk. Peoples' opinions differ as to whether they have in fact lowered or raised their risk when they take a market position. If I were buying a home for my family, would I increase my risk? I don't think so. I've lowered the risk of suddenly having to find another house. If I were in military service and had to move three years from now to another post, I might as well, if I bought a house, prefer to sell a forward contract for delivery of the house three years from now at say 20 percent less to take care of depreciation. Then I would know what it would cost me to use that home for three years. What risks are involved in these transactions? Risk has mean ing only as you understand a person's total business. The idea that you can just look at what a man does in isolated transactions and then conclude that he has or has not shifted risk to someone else appears to be mythology. But I don't argue that it is not serviceable for certain purposes.

We feel that we have a better method of going into the economics of the system than you can get with the usual concepts. Because all you can say, I think is that if you shift risks, you lower the margin at which you offer a service, and therefore, raise the price to farmers and lower the price to consumers. And that ends the analysis. You can correct me, Dr. Gray, if I am wrong. Holbrook Working in his study of spreads published in the early Wheat Studies — magnificent [264] ©1960 Mimir Publishers, Inc.

THE FUTURE OF FUTURES TRADING attempts — did not rely on this concept of risk and risk shifting. So I say that we have an alternative explanation. It is not supplementary. The questions you ask about whether people want to shift risks really are questions on whether they want to assume certain asset positions. We meet this problem but we don't talk of it in terms of whether their risk increases or decreases. I agree with Professor Schruben's point that we do not project the future organizational changes very far. We have done only as much as the data we could assemble would per mit. Professor Larson has concluded from our paper that, with an exception, there will be more specialization. I think this is a basically correct inference. You have more need for capital; the extent to which the corporation can raise capital through issuing more shares has been exaggerated. Most corporations still have to finance their inventories some other way, thus there is a great need for alternative methods of finance. Also we examined certain areas of the integration of opera tions, primarily where the evidence clearly pointed to its existence. We haven't found convincing evidence that special ization has been decreasing. With the growing economy, you may have more big firms and yet just as much dependence on competitive pricing. I think there is room for a good deal of conjecture here. We haven't proved that this is the case, but it seems to be a plausible hypothesis. And I think our view of this implies a projection of the potential of futures trading, i.e. what role it could possibly play if you found in an actual examination of these commod ity markets, that the necessary conditions exist, namely, where you could write a contract that is widely suitable, have a place at which it is commercially feasible to deliver adequate sup plies so you don't have squeezes, and so on and so forth. In [265] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR some cases, there is a need for futures trading but there is no way of writing a workable contract. People won't use it; they have tried it. I think Professor Larson caught the distinction between speculation and hedging that we tried to make. I don't think it is novel. It is not correctly viewed as a difference between price and non-price services. It is a difference of enterprises. That is, it is a difference in what a person commits assets to. MELOAN: We are now ready for questions from the floor. You may, of course, direct your questions to any of the speakers. YODER: I have not really a question; rather I have an ex pression of concern. We have talked around and have some disagreement as to what the function of futures trading is. But from the information which Mr. Goldschmidt pre sented us, whatever the economic services which are provided by futures trading or which were at one time provided by futures trading apparently there has been a considerable de cline in the demand for these services over the years. And so far, it seems to me that we have not very specifically attacked the problem because we cannot agree upon what the services are. We are not firmly convinced what the serv ices are. We are not very well able to evaluate the cause for this decline in demand except, perhaps, as Mr. Goldschmidt has indicated, this demand for hedging against uncertainty is no longer important to the people who formerly used it. And whether this arises out of structure or out of, let us say, a total supply picture which gives people a feeling of more price security than they had before is unanswered. Now, as I say, this is not very much of a question, but it is an ex pression of confusion which exists in my own mind. GOLDSCHMIDT: I left out a couple of pages because I

[266] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING thought the discussion throughout the seminar had been at the level where everybody had probably understood what the government has done to these markets. In my opinion, government activity does two things. One, by owning surpluses, the government assumes the risks for large stocks, and the market doesn't have to do. Two, even for some of the commodities which are marketed through the private trade, the influence that the government supports has on price is such that farmers will carry their grain for ward, relying entirely on the price support as such, even though these commodities may not enter into the actual phys ical stocks of the government. So while I don't think there is less of a need for those serv ices, because our economy has grown, the services which were served by these future markets are now taken up by the government. YODER: In other words, this is a single explanation for it. GOLDSCHMIDT: Well, they have more ramifications, but this was one that I skipped. FLOOR: I was going to say that the loan prevents the market from falling and therefore increases the stability of the mar ket. It eliminates the risk of a decline in price. And on the other side, I think that the thing that makes people feel quite secure is that they will always be able to procure what they need for processing. It is a fact that many processors own elevators in which they store the loan stocks of the Govern ment and they have almost certain knowledge that these stocks will be available to them when the time is ripe. It eliminates their fear that they will not be able to procure supplies. YODER: Then as futures traders you better hunt other markets. FLOOR: Could be. [267] ©1960 Mimir Publishers, Inc. FUTURES TRADING SEMINAR

BROOKS: I noted through all these papers that, whether it was intentional or not, very little discussion was given to integration from the bottom up, from the producer in through the market, as in the Pacific Northwest. Perhaps it is not important, but it seems to be a very significant factor and I just wondered whether some of the speakers might comment on this. They talked about integration from the firm through the system. Now, what about this integration by large coopera tives, producer groups, through the system. Is this impor tant? Is it the same thing? PAUL: Well, I don't think we did an adequate job of exam ining the data on that. We should have examined in detail the statistics on cooperatives. But we do have in the paper a brief statement concerning the movement of growers into other levels, through cooperatives and through arrangements for profit sharing as in beet sugar and citrus concentrate production. These are two methods for by-passing trading in the market. From the evidence it seems that most of these commodity areas are not the areas by and large where there is futures trading. BROOKS: Are they adequately performing the services that were formerly performed on the exchange? PAUL: Your basic question is whether it is more efficient to organize economic activity by integrating, that is, by de ciding within the company to transfer resources from one stage to another rather than by buying or selling in markets? BROOKS: Yes. PAUL: This opens up a big subject. There are many asser tions. I have heard that this competitive pricing system doesn't make sense in a world with rapidly advancing tech nology and large firms. And it is also said that it is too cost-

[268] ©1960 Mimir Publishers, Inc. THE FUTURE OF FUTURES TRADING ly to buy and sell and there are mistakes of price determina tion. How do you reflect what the consumer wants through each stage in the market? Errors accumulate backwards, so that the services are performed wrong, and so on. The idea that the large integrated concern can make better judgements also is a cousin to the idea that the state invariably can do better.

The large integrated firm doesn't escape the problem of pricing from one stage to the other. I suppose that the meat packing trade today shows pressure on the integrated firms exerted by the specialists. It is highly questionable how far this activity can be organized successfully without the use of the competitive market. In an integrated company where you could sell meal and oil to your own firm, often you don't do that. You sell at the highest price you can get and buy cheap. There is a limit on how far the individual mind can con ceive and bring into fruitful decision what the market at large does. I am highly skeptical of the inevitability of or ganizing the agricultural food market through larger and larger units wherein competitive valuation is increasingly avoided. I don't know if that answers your question.

BROOKS: I was just thinking of a specific example where a group of cooperatives had banded themselves together into a selling organization. The producers hold the grain in the name of this selling organization. Furthermore, they have export firms and they have terminal facilities. And even now they are trying to make firm contracts overseas to sell their grain.

PAUL: Well, maybe someone else knows the situation bet ter than I do. MELOAN: Dr. Gray, you had your hand up a little while ago. GRAY: Yes, I did, Thank you. I wanted simply to confirm what Allen said. He used my name and he implied that he might leave it for me to confirm. Certainly Holbrook Work ing did move away from the traditional view that futures markets are places where risk is transferred or from the tra ditional emphasis on this. It is shown most explicitly in his articles Hedging Reconsidered. And at the same time he did also move in the direction of getting away from a dichotomy between hedging and specu lation as you people have done. And I want further to agree with Dr. Paul that the ultimate test of this concept of the futures trading is what it produces in the way of better understanding of the workings of the market. My questions are always comments; never questions. KENDALL: I don't know how pressing it is; it is one ques tion I would like Mr. Goldschmidt to make an observation on. We can appreciate your position relative to the Federal government's activity in supporting prices of agricultural products. I wondered if you would make a comment on the role of the Commodity Exchange Authority, and give us a judgement as to whether this government activity has been good, bad, or indifferent for your business. GOLDSCHMIDT: That is a good question and maybe a good subject for the next seminar and I don't intend to an swer it. But basically I don't have any prejudice against govern ment activities, if that prompted your question. I feel gov-

THE FUTURE OF FUTURES TRADING ernment activity is a helpful thing in many areas and I believe that the C.E.A. and other regulations are probably constructive in giving our market some direction under which we can operate rather than having some of the wilder fluctuating markets that we have had a number of years ago. I believe this even though Tom Hieronymus made the point that actually the limitations on the speculators were put on 20 years ago and proved to be wrong 20 years later by this break in 1958. Generally speaking we probably have more stability because of some of those regulations which, accord ing to some of the speakers, is a desirable aspect.

A Agricultural Price Analysis — Marketing Farm Products — Economic Analysis, 191 B Bachman, Kenneth L., Outlook Conference, USDA, ARS, November 1958, 225 Baer, Julius B., & Olin G. Saxon Commodity Exchanges and Futures Trading, 1949, 13, 123 Bakken, Henry H., Theory of Markets and Marketing, 1953, — 9, 123 Boulding Kenneth E., A. Reconstruction of Economics, 207 Economic Analysis, 215 Brookings Study, 205 C Collins, Norman R. and Jamison, John A., Journal of Marketing, Vol. 22, April 1958, 259 Committee on Agriculture and Forestry, U. S. Senate, 85th Congress on S. 778, S1514, and H.R. 376, Part 2, March 20-21, 24, 26, 1958, 173 Commons, John R., Institutional Economics, 217 Cotton Prices, Hearings before Subcommittee of the Committee on Agriculture and Forestry, U. S. Senate, 17th Congress, April 3, 1929, 208-209 E Emery, Henry C, Proceedings of the Second Pan American Scientific Congress, Vol. 3, 1916, 204 F Foote, Richard J., "Avoiding Nonsense Correlations in Time Series Analysis," U.S. Agricultural Marketing Service, 187 G Gray, Roger W., Speculation Helps the Onion Grower, Minnesota Farm Business Notes, March-April, 1959, 145 Sorenson, Vernon L., and Cochrane, Willard W., University of Minnesota, Agricultural Experiment Station, North Central Re gional Publication No. 42, 1954, 241 H Hart, A. G., Money, Debt, and Economic Activity, 1948, 216 Hicks, J. R., Value and Capital (Second Edition) 1957, 215 Hieronymus, T. A., Appropriate Speculative Limits on Soybean Oil and Lard, Chicago Board of Trade, 1953, 128 The Economics of Risk in Marketing Soybeans, Ph.D. diesis, Univer sity of Illinois, 1949, 133 Hoffman, G. Wright, Hedging and Dealing in Grain Futures (1925), 12 Futures Trading on Organized Commodity Markets in the United States (1932), 16 [273] ©1960 Mimir Publishers, Inc. BIOGRAPHICAL INDEX

Howell, L. D. and Bury, C. W., Institutional Economics, 216, Analysis of Hedging and Other Operations in Grain Futures, USDA Tech nical Bulletin No. 971, August 1948, 188 I Irwin, Harold S., Evolution of Futures Trading, 1954, 14, 15, 128 L Lerner, Abba P., Economics of Control, 1944, 211 M Makower, Harry and J. Marschak, Assets, Prices and Monetary Theory, Economica, N. S., Vol. 5 (August 1938), 204 Portfolio Selections, Journal of Finance, Vol. VII, No. 1, March, 1952, 204 Mehl, J. M., Administrator CEA — Joint Committee of the Economic Report, 11-24-1947, 122 Mehren, George L., Journal of Farm Economics, Vol. XXXIX, May 1957, 259. R Reed, Donald W., Hearings Before Special Subcommittee of the Com mittee on Agricultural House of Representatives, 1955, 238 Reynolds, Robert L., Genoese Trade in the Late Twelfth Century, Journal of Economic and Business History, Vol. Ill #1, 1930. R Rowe, Harold B., USDA Yearbook of Agriculture, 1954, 214 S Schonberg, J. S., The Grain Trade, 1956, 129 See D. Hearings, Committee on Agriculture and Forestry of the Senate on HR 6772, April 1936, 122 T The Chicago Democrat, 1845, 13 Thomsen, F. L., Agricultural Marketing, 1951, 123 U USDA, CEA, Speculation in Onion Futures, January-March, 1957, 123, 142 Usher, A. P., Journal of Political Economy, 1915, 213 W Wesson, William T., Possibilities for Futures Trading in Florida Citrus Fruit and Products, USDA, Agricultural Marketing Service, Mar keting Research Report No. 156, February 1957, 223, 233 — Marketing Research Report No. 241, Agricultural Marketing Service, Marketing Research Division, USDA, 1957, 219 Wheat studies, Financial Results of Speculative Holding of Wheat, July 1931, VII, 176 Williams, Willard F., Journal of Farm Economics, 1958, 225 '[274] ©1960 Mimir Publishers, Inc.

BIOGRAPHICAL INDEX

Working, Elmer, The Effectiveness of Free Market Prices in Allocating Resources Widiin Agriculture, Journal of Farm Economics, 35:784:794, December, 1953, 182 Working, Holbrook, Whose Markets? Evidence on Some Aspects of Futures Trading, The Journal of Marketing, Vol. XIX, 63 American Economic Review, May, 1949, 123 American Economic Review, May 1958, 124, 149 The Theory of Price of Storage, American Economic Review, Vol. XXXIX, No. 6, December, 1949, 175 — Theory of the Inverse Carrying Charges in Futures Markets, , Journal of Farm Economics, Vol. 30, No. 1, February 1948, 175 Hedging Reconsidered, Journal of Farm Economics, Vol. XXXV, November, 1953, 204 — American Economic Review, Vol. XLIII, No. 3, June 1953, 261 Y Yamey, B. S., Cotton Futures Trading in Liverpool, Three Banks Review, 109 Yule, G. Udny, Why Do We Sometimes Get Nonsense Correlations Between Time Series?, Journal of Royal Statistical Society, Vol. 89, No. 1, 1926, 186

COURT DECISIONS INDEX

Board of Trade vs. Christie Grain and Stock Company, 198, US 236, (1905) 23 Bryan vs. Lewis, Ryan and Moody, 386 (1826), 12 Dodge vs. Van Lear, Federal Case No. 3956 (1837), 13 Farmers Milling and Grain Company vs. Urner, 151, Md. 43, (1926) 21 Grizewood vs. Blane, 11 C.B. 526, (1852) 21 Hibble, White, vs. Morine-Meeson and Welsby, Reports of cases argued before Courts of Exchequer Vol. 5 (1838), 12 Irwin vs. Whilliar, 110, U.S. 499, (1884) 22 Lorymer vs. Smith, 1 B. and C. 1, 3 (1882) 12 AVilhite vs. Houston, 200, Fed. 390, (1910) 22

SUBJECT INDEX

Chicago Board of Trade: Agriculture: institution of 73, 79, 84 economics of, 36 —as hedging media, 108 farm population, 250 —branch offices, 85 overproduction in, 250 experiences on, 169 sociological aspects of, 36 formation of, 13, 31 Agricultural Marketing Act, 18 functions of, 31 American Soybean Association, 164 membership of, 85 Arbitrage: —principal offices, 85 between cash and futures, 77 —solicitors, 85 Arbitragers, 90 three services of, 84-85 Arbitration: Chicago Mercantile Exchange, 14, 173 committee of, 34 China, Red: settlements by, 23-24 communes in, 43 Clayton, Will, 308 B Clearing House: Bankers: functions of, 22-23, 30, 34 goldsmiths as, 59 Coat tailing, 141-142 Barter: Cocoa, 50, 63, 115 Stage, 4 Coffee, 27, 51, 63, 68, 73, 75, 78, 88, 90, centers of, 10 100-116, 118-119, 240 terms of, 8-9 importers, 76 Benson, Ezra Taft, 249 Coinage: Bills: systems of, 8 plethora of, 18-19 Commerce: Bills of Exchange: articles of, 6 "Fair Letters", 11 overland, 10 Boyle, James E., 35, 165 Commissions: Bran, 68, 73, 74, 76, 88, 101, 105-106, brokerage, 111 119-120 cost of, 70 Brazil, 109, 114, 115 Committee of Appeals, 34 Brokers: Commodities: —in futures, 248 standardization of, 114 licensing of, 32 storability of, 114 rates of, 34 —successful in futures, 244 Bucket Shops: —suitable for futures, 113-114, 166 form of trading, 58 —unsuccessful in futures, 243 Buffalo Corn Exchange,13 Commodity Credit Corporation, 182- Business Conduct Committee: 183, 191, 231, 242, 247, 248-249 functions of, 34 Commodity Exchange Authority: Butter, 15 attitude of, 122, 164 C conclusions of, 169 Capital: creation of, 18, 32 —net worth of society, 217 criticism of, 173 nonrisk, 111 publications by, 229 risk, 111-112, 118 regulation by, 32-33, 121, 138, 140, Capper Volstead Act, 18 195 Caravan Merchants, 3, 13 reports from, 53 Carrier Acts, 18 reports to, 37 Chicago: role of, 270-271 —Board of Trade, 84 studies of, 80 corn market of, 254 Congress: —elevator capacity, 84 investigations by, 19 —futures, 37 opposition by, 121 —merchants, 30 regulation by, 80 —wheat futures, 83 Contract: wheat market of, 66, 118, 120 commodity futures, 62 —wholesale market, 149 —markets, 32 [277] ©1960 Mimir Publishers, Inc.

SUBJECT INDEX

universal, 50 inventory, 151-160, 174-175, 126-127 Contracts: new factors, 128 —to arrive, 4, 30, 49 —schedule, 126 bilateral, 14, 19 short term, 128 deferred, 33 two sources of, 125 farming, 203, 228-229, 239 E first future, 12 Eggs, 15, 183, 234-235, 239 forward, 214, 228 Emery, Henry C, 56 futures, 15, 173 Exchange: impersonal, 19 long, 122 bills of, 11 negotiable, 15, 19 Chicago, 30 non -negotiable, 11 ideas, 7 open, 128, 143, 148-160, 179, 184, 188, mediums of, 8 190, 230 rules of, 34 wares, 7 —out of balance, 108 Exchanges: parol, 11, 19, 31 commodity, 17 refinement of, 14-15 contribution of, 25 sale, 4 —internal control, 40 short, 122 people make, 40 time, 12-14 public notice of, 17 validity of, 24 responsibility of, 42 written, 31 Exports: "Contracts to Arrive", 4, 30, 49 —programs, 248-249, Cooperatives, 43 wheat, 110 Copper, 27 England: Corn, 30, 37, 50, 62, 65-66, 68-69, 72, —corn market, 7 74, 80, 85, 87-88, 90, 118, 182, 235, 254 futures markets in, 49 Corners, 138-139 Europe: Correlation: famines of, 7 nonsense, 95 -analysis, 148-161, 171, 177-180, 184- F 187 Factors: Cost of Trading: endogenous, 151-152 exceptional bias, 89 exogenous, 151-152, 178 Cotton, 27, 50, 51,108, 165, 208-209, 210, extraneous, 165 229, 236, 243 non-futures, 183 Courts: "Fair Letter", 10 Fairs: "pie poudre," 10 Champagne, 3, 9, 13 Cultural blocks: medieval, 8 to progress 5, 44 seasonal, 7-8 D Farm Credit Administration, 18 Debts: Federal Farm Board, 43-44 Feudal: —claims, 216 —isolation, 6-8 creation of, 59 —peddlers, 8 negotiability of, 216 Floor Traders, 137 saleability of, 216 Forward transactions, 3 Delivery: France, 3, 6, 9 —month, 79 grain market, 7 right of, 27 Futures: —vestigial custom, 27, 51, 54 —commissions, 34 cotton, 108 Demand: expiring, 74, 79 complex, 127 future of, 45, 203-271 conventional, 151-160, 174 inverse relationship, 36 dynamic, 127 manipulation in, 194-196 inelastic, 149 [278] ©1960 Mimir Publishers, Inc.

SUBJECT INDEX

next, 74-79 — in onions, 121, 145-147 pre-, 183 legal status of, 12-24, 38 Futures Contracts: legislators attitude, 16-17 origin of, 15-16 —opposition to, 19-20 validity of, 41 no delivery in, 151-159 Futures Markets: obstacles to, 45 active, 132 —open interests, 87 —based on index numbers, 50-51 origin of, 3, 31, 54 —built on hedging, 129 permits specialization, 220 capacity of, 36 price variation in, 151-160 classification of, 99 progress in, 29 depth in, 94 proponents of, 124 —dominant, 50 —social invention, 45 effective, 94, 111, 113 —stabilizes prices, 132 establishment of, 35 —structural changes, 229-242 —first recorded use, 49 studies of, 165 functions of, 44, 51-60 the future of, 203-271 futures of, 203-271 theoretical development of, 130 —guide to production, 36 theory of, 3-60 importers in, 104 the nature of, 206-223 inadequate, 101 trends in, 232, (ill.) 237, 253 —inanimate mechanism, 79 two approaches to, 130-161, 181 —key assumptions, 95 validity of, 21-23 lopsided, 78 G liquidity in, 94, 136 Gambling: manipulation under, 137-138 definition of, 20 means of improving, 251-252 national lotteries, 20 nature of ownership in, 129 —wagers, 21 nondelivery in, 50 Germany, 6 possibilities of, 113 Gift giving: —price changes (ill.,) 103 ceremonial 3-4 relationship between, 94 equivalent basis, 6 right to deliver under, 49 Gold, 59 variability in basis of, 96-97, 105 Goldsmiths: Futures Trading: —as bankers, 11 —a financial institution, 205, 206 Goods: abusive use of, 48 flow of, 7-8 butter and eggs, 15 Government: chronic threat to, 82 —executive, 16 —circumscribed, 25-26 —interference, 246-247, 267 —commitments, 231 —judicial, 16 —commodities suitable for, 113, 238 —legislative, 16 conventional notion of, 263-264 —stock piling, 81 criteria of, 24, 41 Grain: cotton, 15-16 —exchange institute, 166 dependence on hedging, 62-63 —storage, 84 destructive influences, 7, 138-144 Grain Exchange Institute, 166 dwindling volume of, 245-246 Grain Futures Act, 18 effectiveness of, 61-120, 130 Grangers: efficiency of, 204-205 agrarian attack of, 18 evolution of, 15-16, 25, 45, 48 Gras, N.S.B., 7 faulty, 168 Harvard: functions of, 27-28, 254-255 department of social relations, 46 —acme of perfection, 27-28 Hedgers: historical evaluation of, 1-11 —ability to predict, 107 hedging under, 52 polished, 107 improvement of, 48 role of, 210, 217 —in grain, 31 short, 119 [279] ©1960 Mimir Publishers, Inc. SUBJECT INDEX

Hedging: K. Act of, 22 Kansas: —against grain in-flow, 37 -City, 37, 63, 66 costly, 112 -City Board of Trade, 73 costs of, 70-83, 96, 116 —City Bran market, 76 —defined, 26 —City law suits, 196 —determines open interest patterns, —City market, 90-91 87 —City new business, 255 effective, 105, 116 King, Gregory: "Exceptional bias," 96 form of insurance, 26, 83 law of prices, 167 hypothetical, 89 L importance of, 61-120 Labor unions: —importance overstressed, 52 evolution of, 48 —interesting phenomenon, 129 Lancashire, 209 -long, 66-67 Legislators: measurement of, 110, 116 oversight of, 36 opportunities for, 82 Litigation: —processor, 65 limited 23-24 —relationship to speculation, 64 number of law suits, 24 selective, 70 Liverpool, 108-109, 209 short, 66-67 Longs: volume of, 94 —contracts, 122 H position of, 65 Historical evaluation, 3-60 —speculation, 119, 139 Losses: Holmes, Oliver Wendell, 38 distribution of, 98 Holland, 16 —from long position, 98 I Illegal trading: M bucket shops, 58 Margins: Illinois: minimum, 32 —Michigan Canal, 30 requirements, 32 —river, 30 trading on, 201 Imports: Market: coffee, 110 balanced, 89, 108, 114 Institute of Creative Altruism, 46 English corn, 7 Institutional Economics, 216-218, 258 forward spot, 104 Insurance: France grain, 7 automobile, 58 —integration, 5 Lloyds of London, 57 liquidity of, 70, 83-86, 88, 100, 137, Integration: 215 bottom up, 268 loaded, 107-108 horizontal, 203, 243, 259 lopsided, 89 product, 203 -organization, 223-229 vertical, 203, 237, 239-241, 246, 259 periodic raids of, 17 Intent test: —power, 243 origin of, 21, 44 Winnepeg, 66 Interstate Commerce Commission: Market approaches: —control railroads, 33 agency, 4 transportation rates by, 33 commodity, 4 Iowa, 17 functional, 4, 41 Iron warrants, 12 historical, 42 Italy: institutional, 41 traders from, 3, 9 legal, 42 Market costs: J inverse charges, 102, 107, 175 Japan: Market Fairs: futures markets legalized in, 49 Champagne, 3, 9-10 [280] ©1960 Mimir Publishers, Inc.

SUBJECT INDEX

Marketing: -futures trading, 151-159, 171, 178, commodity, 4 184-185 functions of, 41 Money, 8 "knee pants" status of, 25 N —literature, 4-5 New York, 208-209 Market organization: Coffee and Sugar Exchange, 72 basic tendencies in, 223-229 Produce Exchange, 13 dual nature of, 26-27 New York Stock Exchange: five stages in, 49 formation of, 13 elemental ideas of, 6 function of, 53 leasing in, 262 —not a spot market, 54 phases of, 39 specialists in, 104 progressive gradation of, 3 North Dakota, 17 stages of development, 3, 4, 5, 49 Nutmegs, 12 value of, 7-8 O Markets: Oats, 37, 65, 72, 74, 85, 88, 90, 168, 249 —and production, 39 Onions, 46, 63, 80, 121, 131, 142, 144, bear raiding, 139-140 145-148, 160, 166-167, 169, 173, comparison of, 100 177, 179, 182-183, 188, 190, 194- discount, 101 199 foreign, 250 Ownership: forward delivery, 30 right to dispose, 216 liquidity ratio in, 151-160 risk, 128 limping, 80 zero concept of, 52-53 nature of, 39 P premium, 101 Parsons, Talcott, 46 spot, 4, 5 Market stages, 3, 4, 5, 49 Patterns of trade: Marshall, Alfred, 47 open interest, 62-63 seasonal range, 62 Matthews, Justice, 21 year to year, 63. Maywald, Fred, 191 Peddlers: Mc Leod, Henry Dunning, 217 feudal, 8 Medieval Fairs: itinerant, 8 —complex institutions, 10 Pit traders, 22 European, 8-9 Potatoes, 46, 63, 80, 113, 193, 238-239 France, 3, 13 Practices: Mediums of exchange: unethical, 16-17 —as banks, 43 Prices: -credits, 8-10, 43 asked, 70 Mehl, J. M., 122, 173 average, 130-136 Memphis, 210 behavior of, 221 Merchants Code: bid, 70 origin of, 10-11 closing, 190 "pie poudre" courts, 10 country, 139 Merchants: day to day, 130-136, 145, 158-159, commission, 32 163, 167-178, 181, 185 —specialized, 220 determination of, 40 Michigan: equilibrium, 35, 126-128 Lake, 30 erratic, 17, 122 Millfeeds, 63 —expectations, 144 Minneapolis: —forcasting, 169 Grain Exchange, 63-66, 73 forward, 47 wheat futures, 83, 90 futures trading effects on, 181 wheat market, 76, 106, 118 interim, 126-128 Minnesota: interseasonal, 130-136, 164 University of, 191 leaders of, 141-142 Model: lag in, 184 [281] ©1960 Mimir Publishers, Inc. SUBJECT INDEX

manipulative, 193 Soviet Union: month to month, 130-136, 145, 158- collective farms in, 43 159, 164, 167, 178 Soybeans; 37, 72, 75, 88, 90, 95, 115, negative, 220 133, 164-165, 168, 170-171, 176, objective determination of, 4 198, 235, 239, 240, 249, 263 onions, 150 Soybean oil, 63, 65, 67 positive, 220 Speculation: parity, 172 -a spell down, 136, 172 seasonal, 130-136, 145-147, 149, 164, comprehension of, 124-125 167-178 definition of, 20, 200 spot-futures spread in, 221 —depth, 94 subjective determination of, 4 excessive, 142-143, 168 stability of, 163-164, 172 measurement of, 143 time series, 186 need for, 82 variability of, 121, 124, 163, 177 —a pricing function, 125 variations in, 151-160 nonprofessional, 135-136 Profits: professional, 76 —from long position, 98 proportional volume of, 9 lure of, 8 —relationship to hedging, 64 distribution of, 98 too little, 8-81 zero average, 71 too much, 80-81, 123, 177 Properties: waves of, 144, 188 incorporal, 53-54 Speculators: tangible, 54 activity of, 163 Provincialism, 6 ancillary role of, 207 R —as financiers, 207 —as forecasters, 134-135, 176 Raskin, Ben, 105 —as inventory holders, 127 Ratios: —outside, 127 T-, 71-75 —assumes carrying costs, 208-209 Rice, 166 —assume risks, 26 Risks: —castigated, 121 assumption, 131 classification of, 88, 119 cost of, 133 —discouraged, 247-248 linkage of, 219 hostility towards, 212-214 shifts in, 204 large, 142 underwriting, 131 long, 139 Robber Barons, 8-9 manipulative, 123, 137, 142 Roman Empire: potential, 114 fall of, 6 role of, 210-217 S transactions between, 54 Scalpers, 22, 136-137, 152 Spot markets: Shorts: function of, 27, 51-60 contracts by, 122 major, 10 hedges by, 119 risks in, 52 position of, 65 specific purpose of, 50 sellers of, 213-214 —too speculative, 53 Short sales: Spreaders, 88 cornering, 8, 17 Squeezes, 79, 139, 140 manipulative, 17 St. Louis, 164 prohibition of, 16 St. Louis C of C: squeezing, 17 first grain exchange, 13 Silver, 59 Substitution: Small scale traders, 88 right of, 22 businessmen, as, 90 Sugar, 73, 214 Social inventions: Supply: illustrations of, 43-44 cornering the, 138-139 Sorokin, Pitirim, 46 short-run, 126 [282] ©1960 Mimir Publishers, Inc.

SUBJECT INDEX

Transactions: T-test, 94, 98, 120 bookkeeping, 214 Taft Hartley Act, 44 forward, 3 nonspeculative, 213 Taussig, Frank W., 47 paper, 79, 89 Tennessee Valley Authority, 44 time, 213 Texas, 149, 152, 183 random, 12 Time: forward, 3 flow of, 56 Twain, Mark, 16, 188 lapse of, 56 U Tonnies, Ferdinand, 46 United States: Trade: —as cotton trader, 108-109 —barriers, 8-9 coffee consumption in, 110 international, 8 constitutional government in, 43 spurious, 59 Usher, A. P., 7 tempo of, 6-8 Utilities: — & robber barons, 8-9 Elemental, 40 regularity of, 10 form, 40 volume of, 137 place, 40 Traders: possession, 26, 40 cash, 147 time, 40 cotton, 109 W floor, 152 Warehouse Acts, 18, 32 futures, 147 large, 37 Warehouse receipts: nomadic, 7-8 abuses of, 17-18 issuance of, 17-18 — of Asti, 3 problems of, 32 open interests of, 37-38 sale of, 218 small, 142 title to, 35 speculative, 37 Warfare: uninformed, 123 effects of, 6, 7 Tradesmen: Wheat: 37, 51, 62, 65-66, 68-69, 71-72, rules of, 29 74, 76, 78, 83, 85, 87-88, 90, 100- 104, 108, 110, 112, 115, 120, 140- Trading: 141, 166, 168-170, 179, 193-195, -on basis, 57, 77-78, 89-90, 97-98 220, 243 —on movement, 142 Wilkens, George, 220 state, 243 Wisconsin, 17 volume of, 151-160, 190